By Ted Theodore
About 80 years ago, Gerald Loeb wrote a book about investing that has become a classic and is still at or near the top of any list of favorites for many professional investors, including me. The book is The Battle for Investment Survival. Loeb was a broker who became vice chairman of E.F. Hutton. His central message was that active investing is required in a world where passive investing can be swept away by unforeseen events — events that take a toll on investor psychology and lead, eventually, to costly errors. Thus the battle for survival. But Loeb was very disciplined. He started with, and relied, on the fundamentals of an investment. But if conditions and prospects changed for that investment, he would change.
Our own philosophy has clear parallels to Loeb's principles. As shareholders in companies we are reliant on the record and prospects for those companies - their "fundamentals." To give us a starting edge, we look for information that tells us a corporation is reliably focused on shareholder interests. We then monitor that information and actively respond to change, good and bad, similar to Loeb's prescription.
Unfortunately, corporate accounts do not give a complete picture of whether they are reliable in the way we need them to be. For example, there is a great deal of discretion in the way companies can report their sales and revenues. The same is true for recognition of their costs and expenses. Even more troublesome, there is very little accountability for how intangibles like good will and trade secrets are treated on income and balance sheets. As the economy has become more service oriented and less production oriented, intangible assets have become even more important.
To deal with this challenge and, as a practical matter, we measure our interest in the corporation by whether it is growing its cash. In the end, companies cannot hide behind accounting gimmickry if they cannot grow their cash. So we start with the Statement of Cash Flow. This account adds non-cash charges (like depreciation and good will) back to operating earnings. It also adds back net changes in both working capital and financial capital. Finally, because we think there is added protection for shareholders in companies that invest in their future, we subtract those capital expenditures which are needed to sustain the business. What we end up with is "free" cash flow. While not foolproof, emphasis on changes in free cash flow becomes a benchmark for discerning whether a company is strong or not.
Even with a difficult start to the New Year, no one really knows what lies ahead for investors. The environment of the last four years favored the broad category of companies that were buying back their stock. Our process should continue to benefit if the future looks like the recent past.
But now that the Federal Reserve has initiated the first tightening in monetary policy in about a decade, we would expect that companies that finance their growth through free cash flow have a better chance to excel than those that have only used debt to buy back their shares, debt that could become more expensive.
Those stronger balance sheets and the history of growth in free cash flow would likewise provide a cushion should the economy roll over into recession.
At the other end of the spectrum, if some of the macro concerns gradually recede, then it is probable that investors will become less cautious and begin to focus on companies with well-financed organic growth like ours.
Ted Theodore, CFA is vice chairman and chief investment officer of TrimTabs Asset Management and portfolio manager of AdvisorShares TrimTabs Float Shrink ETF (NYSEARCA:TTFS).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: AdvisorShares is an SEC registered RIA, which advises to actively managed exchange traded funds (Active ETFs). This article was written by Ted Theodore, CFA, the portfolio manager of the AdvisorShares TrimTabs Float Shrink ETF (TTFS). We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article. This information should not be taken as a solicitation to buy or sell any securities, including AdvisorShares Active ETFs, this information is provided for educational purposes only.
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