CASH FLOW IS KING


By John Nicola, CFP, CLU, CHFC

Read this tactics newsletter in PDF format.

A cynic is a man who knows the price of everything and the value of nothing

– Oscar Wilde

2016-04 Cash Flow Is King - In This Issue - Summary
As 2016 unfolds, one could replace the word cynic with fearful investor and have a reasonable description of the year’s investment markets.

Let’s imagine that at the end of 2014 there was an investor who had a single asset. It was a well-run apartment building which was appraised at $5-million. It generated an income of $200,000 per-year after expenses. With a lot of work and some reduction in vacancies, he increased that income to $210,000 by the end of 2015. He began to think that perhaps now would be a good time to sell, become more diversified, and look for investments that do not occupy so much of his time. After all, there are only so many times that unplugging toilets at five in the morning can be considered “exciting.”

He has a trusted friend who is a licensed realtor and he asks him to list the building with the idea of selling to the highest bidder. One month later his friend visits to tell him the following:

“Fred (all apartment owners are named Fred – remember I Love Lucy?), I have some bad news. I listed your building and received five bids for it.”

“So why is that bad news, Bob? There are five investors competing for my building!”

“Because, Fred, the highest bid is $4,000,000 and the lowest is $2,500,000.”

“That can’t be right. The building earns 5% more than last year. Mortgage rates are about the same and the economy is decent – what gives?”

If you think as Fred does, and cannot understand how the price of an asset can fall by 20% to more than 50% while its income remains the same or increases, then welcome to the irrational world of public markets.

Price Vs. Value
Below are some companies, asset classes, and funds that have dropped significantly in price over the last year and yet have maintained or increased their yields.

2016-04 Cash Flow Is King - Price Vs Value Chart

It is always possible to rationalize why these “corrections” occur:

  • Lower interest rates will mean that some types of preferred shares will renew with lower dividend payouts.
  • Bank earnings in Canada have peaked and will be negatively impacted by energy loans and the overall Canadian economy.
  • Companies have too much debt and the default rate for high yield bonds is going to rise; there is a flight to safety.
  • Low oil prices are here to stay and many energy companies will not survive.

In each of these scenarios there is enough truth to make a rational investor make irrational decisions, and over the last 12 months that’s exactly what has happened.

The first time we wrote about this topic was at the end of 2007. Markets had already dropped from their peaks, but much worse was yet to come. By the time the nadir was reached in March of 2009 the collective fall in equity markets was in excess of 50% and some asset classes, such as REITs, fell 70%.

Yet in most cases dividends held up and, as a result, yields on equities, high yield bonds, preferred shares and REITs dramatically increased, in some cases reaching low double digits.

Buying quality cash flow had not been this inexpensive in well over a generation. Yet most people wanted to sell and move to “safety.”

Most investors do not appreciate how much the cash flow generated by different asset classes is responsible for the total return. In addition, young investors who are many years away from retirement may say that they do not require cash flow from their investments and perhaps they would be better off investing in “growth” assets versus ones that distribute cash on a regular basis.

Our argument is that sustainable or growing cash flows create higher value for your assets. The more cash you generate now, the easier it is to diversify and buy assets whose prices may be temporarily distressed (such as the ones noted above).

Dividends And Total Return
If you have any doubts about the importance of dividends with respect to total returns and rational investor behaviour, consider the following:

  • From 2000 to 2016 the price appreciation of the S&P 500 was only 17% (about 1% per year in what has arguably been a very long secular bear market). When one includes dividends, those cumulative returns increase to 61%. The results for the TSX are similar; the index has appreciated 30% since January 2000. That number increases to 92% when one includes the impact of reinvested dividends.
  • The IPD Index measures institutional real estate prices and total returns in 25 different countries. Their results for Canada show that between 2000 and 2014, investment-grade real estate appreciated by an average annual rate of 3.6% per year (before fees), but that the total return (including net rental income reinvested) was 10.9% annually before fees (7.2% per-year more). This means that $1-million invested in January of 2000 would now be worth $1.6-million based on price alone (net of fees), but more than $4.5-million total return (which includes the impact of receiving rental income net of fees).

To us dividends, rents, and interest payments are the critical element in building a portfolio that will have the following attributes:

  • Consistent and stable cash flow so when you require your assets to support your lifestyle in retirement, it can be accomplished through the income generated by your portfolio. Consequently, if markets drop, you will not need to sell assets at distressed prices to meet your spending needs.
  • High cash flow strategies that regularly generate funds for purchasing additional assets at opportune times. This creates a type of dollar cost averaging which is very effective when used to acquire assets after prices have dropped significantly (in this environment: public stocks , preferred shares, and high yield bonds).

That is why we created the two reports below that focus on the historical and future cash flows in our clients’ portfolios.

Historical Cash Flow Summary
2016-04 Cash Flow Is King - Historical Cash Flow Summary
This report shows a summary of the 12-month rolling average cash flow by quarter since the end of 2003 (for those who had accounts at the beginning of 2003) or 12 months after your accounts were open. The 12-month rolling average evens out those cash flows that are sometimes paid either quarterly or annually. There is an additional report showing which assets generate current distributable cash flow and how much that totaled over the last 12 months. History suggests that these cash flows are much more stable than asset prices.

Estimated Projected Annual Cash Flow Summary
2016-04 Cash Flow Is King - Projected Cash Flow Summary
As the name suggests, this is a forward-looking report which provides an estimate of the cash flow that may be realized in your account over the next 12 months. We strive to ensure that at least 50% of your long-term total return is generated from cash flows in the form of dividends, rents, and interest. This report (shown on the next page) shows where we expect to see that cash flow come from and in what amount.

You will also see some assets that do not generate cash flow at all. This does not make them inferior assets.

There is some argument for acquiring assets that are all about long-term price appreciation (land versus income-producing buildings would be the real estate equivalent). You will also notice, however, that assets acquired primarily for growth reasons are usually less than 25% of the entire portfolio. Cash flow still dominates.

We hope these reports provide some perspective on your portfolio and help you focus on those areas that truly impact long-term wealth building:

  • Prices will always fluctuate more than income, and that is especially true of publicly traded markets.
  • In order to buy well, we need the assets we want to acquire to drop in price (at least for a while).
  • In order to acquire those distressed assets, we need cash flow being generated from a well-diversified portfolio, thus allowing us to sell some “winners” as we buy some “losers.”

So just for a minute let’s go back to poor Fred. What’s he going to do now? Of course he could feel depressed about selling his building and getting, at best, $1,000,000 less than a year ago, or…

  • He could feel elated that he can now buy another building for twenty percent less than a year ago. Mortgage rates are the same, so this is his chance.
  • With two buildings he will have more cash flow than before, so he decides to hire a property manager and let them unplug the toilets.
  • He then takes Ethel out for dancing lessons with Ricky and Lucy at some new Cuban place.
  • And all is right with the world.

(No apologies required if you have no idea who these people are – It’s a boomer thing.)

King piggy bank front

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, fees, estimates, and certain information contained herein are based upon past performance of a given investor profile and should not be considered as generic investment advice or a recommendation of any particular security or investment product. Please speak to your advisor regarding your own unique situation and investing needs. Past performance is not a guarantee or a reliable indicator of future results. Investments of all kinds contain risk and may lose value. Investors should be aware that the holdings in their portfolios differ from the holdings that make up any index in order to understand why their portfolios may perform differently.
COMMENTS (2)
Palkesh Khandelwal said on August 29, 2016 @ 2:30 am

I like your newsletter.

Can u please start sending me through mail.

Victoria Grady said on August 31, 2016 @ 9:56 am

Thank you Palkesh,

We’re pleased that you enjoy the newsletters.

Please send your mailing address to [email protected] and we will ensure that you receive a hardcopy of the newsletter.

Sincerely,
Victoria

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