Shares will be running a series of Christmas features explaining the top 10 golden rules of investment
In his book Making the Right Investment Decisions: How to Analyse Companies and Value Shares, former SG Warburg equity analyst Michael Cahill warns: ‘When considering the accounting methods used to arrive at the earnings number, it pays to be sceptical. Management’s credibility and rewards are intimately connected with delivery of earnings targets.’ For this reason it is important for investors to focus on a company’s balance sheet first, cashflow second and profit and loss account third – nearly everyone does it the other way round so by focussing on what really matters you are managing risk more effectively.
If stated earnings are rising but cashflow is not then you need to ask some serious questions. It was only by booking revenues early, before it had been paid for the work, that one-time darling of the social housing sector Connaught managed to deliver spectacular earnings growth.
Analysis of the cashflow statement would have revealed this accounting sleight of hand. One of the quickest ways to check a company’s cashflow credentials is to explore its track record of growing the dividend, as these distributions can only be made out of real cash, not tarted-up paper profits.
Given his status as one of the world’s most successful active investors it is intriguing to see Warren Buffett use his 2013 shareholder letter to plug the attractions of a simple S&P 500 tracker fund, preferably Vanguard’s. Read on and it becomes apparent the Berkshire Hathaway (BRK/A:NYSE) man is making a more subtle point.
Buffett is really saying that if you are not able or prepared to do the research so you can get to grips with a firm’s business prospects by a study of its competitive position, pricing power and ability to generate cash (see rules number three and four), then you probably should not be buying individual stocks. In this case a low-cost collective tracker which provides broad market exposure can be a good idea. ‘The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal,’ Buffett writes.