Portfolio Rule Six

I am more optimistic over how my asset management practice will start.  Thanks to all who have expressed interest.  Depending on how the state of Maryland replies to my filings, I will be able to get started sometime in November, December or January.  At present I am interviewing custodians who be clearing brokers.

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Cash flow is the lifeblood of business.  In analyzing management teams, there are few exercises more valuable than analyzing how management teams use their free cash flow.

With this rule, there are many things that I like to avoid:

  • I want to avoid companies that do big scale acquisitions.  Large acquisitions tend to waste money.
  • I also want to avoid companies that do acquisitions that are totally unrelated to their existing business.  Those also waste money.
  • I want to avoid companies that buy back stock at all costs.  They waste money by paying more for the stock than the company is worth.
  • This was common in the 50s and 60s but not common today, but who can tell what the future will hold?  I want to avoid companies that pay dividends that they cannot support.

Intelligent companies pay a reasonable fraction of the earnings as dividends.  They only buy back stock when their stock is cheap.  They don’t buy their stock back when their stock is sort of cheap.  They only buy it back when it is cheap.

And as for mergers and acquisitions, intelligent companies don’t do large-scale acquisitions.  Instead, they do little infill acquisitions.  They do acquisitions that give them a new technology to extend their business.  They do acquisitions that give them new markets distribute their products or services through.  In general, they do acquisitions that allow them to grow more effectively organically.

Organic growth is what it’s all about.  Anyone can do a stupid acquisition, and give the appearance of growth, but real organic growth is hard to find; it is the acid test of determining what is a good management and what isn’t.

That brings another point to mind.  Unlike many investors, I don’t mind if intelligent managements hang onto cash.  Cash is valuable in the hands of the bright men.  It gives them flexibility during times of economic stress.  Giving intelligent management teams additional flexibility is a good thing.

When you hear the phrase “transformational merger,” hang onto your wallet.  Most big mergers do not achieve the goals that they were designed to achieve.  And as I said before, the best management teams are not looking to grow rapidly through mergers and acquisitions.  Rather, they do little acquisitions to facilitate organic growth.

That’s all for this rule.  If you want more information on this topic, you can review this set of five articles that I wrote for RealMoney.com, that are freely available on the web.