Cash Flow is King, But Sometimes it Isn’t

In my younger years I was too focused on hard and fast rules.  Rule 1 was cash flow is king.  Rule 2 was buy cheap.  If a company wasn’t generating meaningful cash it fundamentally wasn’t worth investing in.  I wouldn’t even consider Rule 2.  After all, a company is worth the cash it generates in the future; discounted to today’s values.  Below is a model that illustrates this concept.  Each cash flow has a 10% discount rate applied to it.

*Assumes a 10% required rate of return

You can see how much weight the early cash flows have to the calculation. Which is to say that $100 generated in “Year 1” is worth $90.91 in today’s dollars while the $100 generated in “Year 10” is only worth $38.55 in today’s dollars.  Therefore, the cash flows at the end of a 10 year model need to be substantially larger than the near term cash flows in order to be worth the same amount in today’s dollars.  This impact is exacerbated when near term cash flows are negative.   

That has always been a hurdle for me because I lack the confidence to  accurately foresee cash flows 10 years from now.  Furthermore, the required growth in cash flows caused greater uncertainty and doubt.  A negative consequence of that mental barrier/bias is I almost always missed out on growth companies because they tend to use cash while they grow.  Thus, current cash flows in growth companies are not representative of mature cash flows.  A recent presentation by Aswath Damodoran illustrated this point with this slide:

Source: https://www.youtube.com/watch?v=c20_S-QgvsA&t=2s

Damodoran highlights the cash needs of companies in different life cycles very well in that slide.  In my experience, a lot of money can be made investing during the high growth part of the life cycle (assuming you pay a reasonable price).  I believe the reason stems from the fact that the future is still uncertain so it’s still possible to have  investing edge (Note: the dispersion of future cash flows in growth companies arguably means there is more risk associated with investing in them). 

Most people can reasonably forecast the future of Coke.  Forecasting LaCroix’ future is more difficult.  Furthermore, Coke’s valuation very driven by existing cash flow rather than future cash flow.  Thus, it’s less likely to be materially mispriced because everyone is looking at the same information in the same way.  This makes buying Coke very cheap very difficult and probably limited to severe market corrections.  Waiting for those opportunities probably isn’t the best investing strategy because holding cash and waiting for a crash can cause behavioral mistakes.

I’ve learned from my mistakes and now try to look at a business or investment at the time of maturity.  I would not summarily dismiss purchasing a building during the construction phase while it was not earning maximum rent and was consuming cash while contractors completed renovations/build out.  Buying a business is no different.  

Making money investing is a difficult pursuit.  Nuance and flexibility are rewarded much more than hard rules and style conviction.  As I’ve let go of my style as a “value” investor looking for cheap cash generation I’ve begun to see opportunity in buying smaller firms at growth inflection points.  The key is determining which part of the life cycle a firm is in and analyzing that particular situation accordingly.     

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