In our most recent series written by Jamie Cornehlsen, Denver CFA and founder of Capstone, FLOW examines how we seek out investments and make selections based on current market trends and future forecasts. Part five of our series dives deeper into portfolio development and helps readers understand what creates value in today’s changing market.
The downturn the stock market experienced in the final weeks of 2015 and the first few weeks of 2016 set up a prime time to invest.
I went into the new year thinking that I would take on five investments at a time. If the market fell, I would buy the next lot.
As chance would have it, the first lot was purchased on January 12th. The following lots were purchased on January 15th, January 19th and January 20th.
The portfolio was invested more quickly than expected, but the declining prices in the market provided a favorable opportunity, with a jump in current yield occurring right off the bat.
Removing the Panic from Portfolio Development
The declining prices have led many investors to fret over their portfolios, with the anxiety and fear being that they will lose all their money. But if the investment was made with the belief that the company will not only continue to generate cash flow, but overall growth in the future, then the anxiety is more emotional and less analytical.
I have observed that poor investment decisions are often dictated by price movement. However, price movement is very different than a company’s ability to continue generating earnings and to grow those earnings over time. There are times when a decline in price reflects verifiable concerns, but price movements alone can be very misleading. A rising stock price may put an investor at ease, creating a false sense of security.
Investors make mistakes when they let emotion creep in and impact behavior and investment decisions. When plowed over by the hype from greed or the hysteria from fear, investors seldom make rational decisions. This type of behavior only creates optimal opportunities for those not falling prey to emotions.
Value is what you get; Price is what you pay
I seldom hear of investors providing the price they are willing to pay in order to generate a stream of cash flow. In our FLOW portfolio, we were willing to pay $150,000 for a stream of cash flow of $17,580 annually, or 11.72% of the portfolio.
I don’t know if this is what will eventually come of it or if the portfolio will be significantly lower, but I wanted to make sure the price of $150,000 for 20 different investments could create a value worth at least $15,000 a year (in this case $17,580).
Value is different than price because value represents cash flow to us. Since we are value-conscious investors, we are intently keen on paying attention to potential cash flows that are expected to be received. Unfortunately, few investors spend the time necessary to focus on this critical element. Instead, many financial brokers’ attention is placed on stock price and its up or down pattern of movement.
If you pay too much, you receive very little value. No matter the amount of cash flow a company generates, the overall impact felt is the price that was paid to buy that investment. When purchasing an investment, you can often determine the value by how much cash flow is being received now, as well as in the future.
As I mentioned before in FLOW: Volume 1, Warren Buffett’s investment philosophy is all about value in purchasing a stream of cash flow for as little as possible. His quote, “Price is what you pay. Value is what you get” clearly summarizes this.
With the $150,000 invested in cash flow generation, my thinking now turns to the possibility of buying the whole company as the investment process begins.