We’re pleased to share this five-part series on investment, from one of our Directors, Paul Reilly. Paul has had a long-standing career providing financial advice and in this series digs into some important investment principles to increase your understanding of sound investment.
EXPLORING INVESTMENTS: ARTICLE 3 – BEHAVIOURAL BIASES – PROFIT VS. CASH FLOW
Despite best efforts, there are often behavioural biases in investing.
In Article 2, we explored quantitative analysis, and discussed two businesses with different reporting styles. As discussed, often a business is rated higher due to a focus on profits. Cash flow receives far less attention.
Let’s look at how that impacts investing.
Professor Sloan’s Study of Investments
The focus on profits was analysed and reported by Professor Richard Sloan, a professor at MIT in the United States. He studied the U.S. market between 1962 and 2001, and found that investors focus far more on reported profits than cash flows.
Looking back at our example in Article 2, Donald’s business had $50 in revenue with one delinquent payee; he reported a net income of $50, cash flow from operations at $40, and an accounts receivable of $10.
Sally also had $50 in revenue with one delinquent payee; she writes off the delinquent $10, and reports $40 in net income. Sally’s net income, net profit and cash flow line up, each at $40, and she has no accounts receivable.
Professor Sloan actually started a hedge fund and bought companies like Donald’s and Sally’s; he identified companies like Sally’s, which were actually underpriced by the market. He sold companies like Donald’s that he felt were overpriced by the market, because investors weren’t focused on cash flows. That’s an often-unknown investment bias.
In Australia, Financial Framework‘s investment partners replicated his research and used the same formula as Professor Sloan did in looking at the U.S. market.
That formula is: scaled total accruals, which is the sum of the difference between the net income and cash flow from operations, divided by total assets. This provides an idea of the discrepancy relative to the size of the business.
That differential was analysed over a number of years. Here’s what was found.
The Australian Market
In studying the Australian market, we found that the results of Sloan’s research were absolutely replicated, almost 20 years after his initial research. That behavioural bias in investing was the same in Australia.
In other words, cash flow is an important consideration that’s often overlooked in favour of a focus on profits.
If a company can consistently not generate cash flows to validate reported profits, maybe something’s up. It may not be a definite problem, but it doesn’t line up, and that’s a filter that leads to looking beyond to other companies.
One way to do that is to remove the worst quintile, or bottom 20% of companies in terms of cash flow vs. profits.
Investing does not have black and white answers, but what can be done as an investor is to make multiple distinctions. Each of those distinctions should put the odds slightly further in the investor’s favour.
In looking at the top 100 companies through this accruals filter, the bottom 20% of companies would be removed based on that cash flow distinction. That will leave 80 companies to go through value filters and quality filters. In the end, there are 15 companies to invest in for that half of the portfolio.
That filter is done on an annual basis. While it’s good to review and re-invest, it’s also important not to have a high turnover of investments, while also being tax effective in terms of capital gains.
Final Thoughts
At Financial Framework, that kind of analysis is done to guard against behavioural biases and ensure an investment portfolio that works for our clients.
We believe we have constructed some of the best managed funds in Australia, with a focus on beneficial ownership and transparency.
Contact us today to find out more.
