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Tuesday, June 28, 2011

Notes from the USA (Jun 2011) – a guest post

One of the best ways to find out about the true state of financial health of a company is to scrutinise its cash flow statement. The Profit and Loss statement is based on the accrual system of accounting. The cash flow statement records the actual inflows and outflows of cash, which provides a better idea about the sustainability of a company’s business model.

What about an investor’s cash flow statement? Are you keeping track of exactly how much cash inflow is being generated by your cash outflows (i.e. investments)? Specially in a sideways or sliding stock market? In this month’s guest post, KKP shares some of his thoughts on the subject.

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Lets Get Down to Cash Flow Analysis

Q1 and Q2 2011 have shown that there might be a good size recovery, giving a feeling of hope to many people in the US, as well as corporations. The economy has slowly been recovering – no doubt. But the housing and construction market rebound has remained soft despite the big QE (quantitative easing) programs from the Fed and the low-low-mortgage rates (average 30-year fixed U.S. mortgage rate is around 4.82%). The reason is simple: Stubbornly high unemployment and underemployment, and also tight lending policies from the bankers/lenders. Bankers have swung the pendulum to the other end of the spectrum and have very stringent policies. In 2002-2008, lenders would lend money to people without any money down (by doing double mortgages), and today, even if someone is providing 25% down payment (upfront cash), they are scrutinized as if they are one of the worst borrowers.

Predictions show that home prices will fall around the 5% to 10% in 2011 compared to 2010, and they will remain flat in 2012. This median forecast was part of a poll by Reuters of 21 economists who provided price forecasts. In looking at really long term trends of US home prices, it clearly shows that home prices are close to the bottom and will hover around here for a bit, and with a ‘core-recovery’ we will see a bounce up in prices (albeit very slowly).

"It is hard to see the housing market doing better until the massive headwind of foreclosures is removed and that will likely take a couple of years," said Mark Vitner, senior economist at Well Fargo Securities in Charlotte, North Carolina. With home prices still falling, many potential buyers are sidelined and banks are more stringent with loan applications and credit scores, Wells Fargo's Vitner said. "It is not that I am pessimistic about the housing market, it is just that I am not optimistic and a gradual recovery probably will not happen until 2013 or 2014, with a full normalization not until 2015," he said.

I have noticed that there is a rise in the "distressed, foreclosed and short sale" homes due to the fact that the lower home prices have put mortgage balances (what you owe on the home) above the current price of the home. Therefore, the home either goes into a short sale (seller and lender put it on the market), or foreclosure (owner cannot or will not pay mortgage), or distress situation (seller does not pay mortgage, and lender cannot afford to keep the home on the books). The net result is that the price of the home has to be marked down significantly, for investors or home-upgraders or renters are willing to look at the properties.

I am currently sprucing up a home that I purchased as a ‘distressed home’, and will be renting it out before July 1st, 2011. In addition, have offers out on Short Sales where the Seller and Lender are considering my offers for Downtown Condos (at 1/3rd to 1/4th the last sale price). Even with the above flat market situation predicted, I remind myself that I am buying real estate at the “equivalent of March 2009 Sensex prices”. Remember how undervalued we were in the stock market at that time, before we took off? Real estate will NOT take off in the same manner (of course), but my tarot-charts (figuratively speaking) is telling me that I am buying it close to the bottom and have no desire to price these out for sale since I will be renting them out in the near term (2 to 5 years).

In addition, I am buying these at really ‘distress’ prices, instead of chasing them, and have the ‘patience and privilege of dividends’ while I hold. Dividends are in the form of rent here so it is easy to convince myself to hold. So, equate it to holding a stock that may not move up immediately, but will pay you almost risk free 12% to 26% in return with minimum loss of capital (if so).

Bottom line is that a lot of books have been written about ‘cash flow’ production, and with this methodology, I have found how much of a parallel it holds to Selling Calls on individual stocks being held in a portfolio. Call Selling had been a very favourite methodology of mine when I was very active in the markets in the 1990’s, and most recently as a way of reducing my stock holdings. But, in both cases, it taught me how to ‘generate cash flow’ from the holdings, and ‘make a paycheck’ out of it.

Real estate has the power to make the same with almost the same amount of time involvement. Wow. Really? Yes, very true. In India, it is even better since you can literally buy a flat/condo and rent it out, making all responsibilities of maintaining the flat a responsibility of the tenant (minus big issues). I am able to replicate the same with a team of contractors to simplify my life and do virtual-maintenance (call someone to go and fix it at low cost).

For now, think cash flow, and figure out a way to generate a paycheck or cash flow from your investment holdings. If you hold RIL or HUL for a long time, the percentage yield to your purchase price could be significant enough to get a very net high yield, especially if the stock has provided splits/bonuses. With my net-buy-price of HUL under Re 1.00, the percentage yield on the annual dividend seems like a paycheck each time it comes. So, there are many ways to skin the cat, and as one gets more experienced, some of these techniques become part of the portfolio and life, and yet, it is each portion of the portfolio that needs to replicate the ‘cash flow’ generation methodology. Traders might be good at generating cash flow from ‘trading’, but very few can do it consistently, and hence doing it with many techniques/strategies will be good for your long term financial health.

Hope you can ‘draw’ some ideas from this to your thinking and add a twist to your investments that might change the overall short and long term return, such that it gives back some cash flow which can help with your own personal goals (buying gold or silver)…..Oh, that brings me to another favorite topic of mine (gold), but we will leave that for the future….

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

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