Saturday, September 24, 2016

Do not buy when a listed company makes record profits

Do not buy the shares of a listed company when the newspapers report that it has made record profits.

If you hold the stock of the company, you can choose to sell it or to hold on for special dividend.

If you do not have the stock, and you happen to buy early in the morning at a relatively low price, you have to sell it by the end of the day to lock in the profits.

The share price rarely rallies much after the newspapers report about the record profits.

Why?

The insiders have already stocked up the shares before the financial result is out, and they are not going to buy at a high price.

The existing shareholders or in the same industry or those who have followed the announcement closely have anticipated the record profits for the current year.

A listed company does not make a record profit all of a sudden.

For a property developer, the record profits come when it has a few projects gaining the TOP (temporary occupation permit) signaling the completion of the project.

If each project yields 2000 homes, and all are fully sold, you can expect a bountiful year, since they can only recognize the bulk of the revenue after completion of the construction.

In the years that the homes are being built, they can recognize only a small percentage of the revenue. 

At the point of TOP, they can recognize 100% of the revenue.  That leads to a very volatile profit and loss statement.

I do not know why the newspapers reporters always focus on the profits, and not on the cash flow.

If you look at the cash flow in relation to the profit and loss statement, you will find a few very puzzling things.

Sometimes a company can have a record profit, and yet the cash flow is negative.

That means the cash at the beginning of the year is higher than the cash at the end of the year.

If a company makes $2 billion profit in a year, and yet the cash in the bank is much lower, where does the money go?

The money can go to the repayment of bank debt or redemption of corporate bond or expenses associated with new projects or to capital investment in the form of a bigger premise or the acquisition of another company.

That is why do not focus on the profit. 

Focus on the cash flow. 

If the cash flow is negative, you can find out the reason for it.

If you do not think that the company is spending money wisely, do not buy the shares.

For example, the company uses the money to acquire another company.  You do not think that is a good thing, since the acquisition leads to higher debt and burns away the existing cash.

If that is the reason, you can wait for a year or two to see if the acquisition makes sense.

The focus is always on cash flow, not the profit.

There are instances where companies report a loss, and yet the cash amount increases.

The loss can due to depreciation, or a markdown of the inventory known as impairment loss.  It has nothing to do with the cash.


The cash keeps coming in, and yet the company keeps reducing the value of the inventory.