CLARITY OF RESOURCES

FINANCE RECAP

‘Know what you own, and know why you own it.’
― Peter Lynch, Retired Investor, from his book ‘One Up On Wall Street’

If you have any type of investments (retirement), or you run a business, it’s critical you know some Finance Concepts. This is like a review of your Money Owner’s Manual. Read the manual to Increase your current Money Stockpile. Let’s start with a Recap.

Finance Down to 7 Concepts:

• Price v Value
• Mean Reversion
• Capital Allocation
• Compounding
• Risk
• Credit Capacity
• Analysis

* The definitions were care of Investopedia

Price v Value –

Understanding the difference between the two, when you Analyze Assets. ‘Price is what you pay (arbitrary), but Value (fundamental) is what you get’ – Warren Buffett. An investor needs to understand value, and be able to leverage the difference between price and value. You want to find stocks of good companies selling at a ‘below market’ price. A company may be good, but their stock is only good at a certain price. If it is overvalued, then you will not make a good return.

Ben Graham‘s classic book ‘The Intelligent Investor‘ has 2 chapters that should be mandatory reading – Ch. 8 (on Mr. Market), and Ch. 20 (on Margin of Safety). Warren Buffett based his entire investing career on this book, paying particular attention to the brilliance of these 2 investing essays.

Mr. Market (Ch. 8) – Graham calls the Stock Market aka Mr. Market, and says he is an emotional fellow. He will show you vast fluctuations on the stock price, and you must not get emotional when analyzing if the offer is good or bad. Because Mr. Market is so emotional, tomorrow he could offer a different price. Graham was pointing out, that the market is about people, who are buying and selling these stocks, and their actions are not always rational. This provides opportunities and pitfalls. Do your homework and determine the fair value of a stock, then buy when the market offers your price.

Margin of Safety (Ch. 20) – Because Mr. Market’s prices fluctuate, combined with the fact that your analysis of a stock may be off (or the economy could take a dip), you need to have a ‘Margin of Safety’. This means you have a 20% buffer (pay 20% less) from what you will pay. Use calculations to determine the price you will pay, estimating the potential of a stock and what yield you may get. Investing (like Business) is not a ‘Hope’ exercise. You write down your analysis and make judgments without emotion (see Ch. 8).

Mean Reversion –

Mean Reversion, or reversion (or regression) to the mean, is a theory used in finance that suggests that asset price volatility, and historical returns eventually will revert to the long-run mean or average level of the entire dataset.

Prices do not go up forever, they tend to level out over the long term. This is why so many investors monitor the 52 week High / Low average of a stock, and how it is trailing. Many stocks will go up 5, or 10 – 20% in  a year, and then go back down – whether because they are cyclical, a ‘hot buy’, scandal with the Co., or market circumstances, etc.

Market Cycles, also known as stock market cycles, is a wide term referring to trends or patterns that emerge during different markets or business environments. During a cycle, some securities or asset classes outperform others because their business models aligned with conditions for growth. Market cycles are the period between the two latest highs or lows of a common benchmark, such as the S&P 500, highlighting a fund’s performance through both an up and a down market.

Market Cycles, are common as economic phases rise, then fall. Think of this like a like a Pendulum, and pay attention to how they are moving currently. A great example is a Recession, where the market is down for 6 to 10 months, and stocks are all falling. As the economy comes out of the Recession, there are many opportunities for buys of the stocks of good companies that were down from the Recession, but now are rebounding.

Capital Allocation –

Capital Allocation is the process of distributing financial resources to different areas of a business to increase efficiency and maximize profits.

A Sunk Cost refers to money that has already been spent and which cannot be recovered. In business, the axiom that one has to “spend money to make money” is reflected in the phenomenon of the sunk cost. A sunk cost differs from future (or regular) costs that a business may face, such as decisions about inventory purchase costs or product pricing. 

Sunk Costs also mean that the Money $ used on a bad investment is lost. Don’t try to ‘chase it’ to somehow recover and get even. Instead, just write it off, and move on.  It is better to use the New Money $ on better investments. Where to Invest your money $ is pivital to Capital Allocation. Simply put, learn to Control Your Capital and decide wisely what Opportunity (Cost)  it should go to be as efficient as possible. This is the intersection of scarcity and choice.

Opportunity Cost is the loss or gain of making a decision, the forgone benefit that would have been derived by an option not chosen. To properly evaluate opportunity costs, the costs and benefits of every option available must be considered and weighed against the others. Famous Phrase – “idle cash balances represent an opportunity cost in terms of lost interest”

In Stock Investing – Beware the Zombie Co.s in the S&P Index. These are companies that are not profitable, or growing (may even need a Bailout). They are just treading water, and paying their interest on debt, but not their principal. In the current S&P index, it is estimated that about 20% of companies are Zombie Co’s whose main investment comes from people buying the whole Index. Unfortunately another 30% of the Index are bad companies that are either are stagnant, or on their way to Zombie status. Maybe 10 – 15% of the Companies (Stocks) in the Index (50 – 75 Co’s) are really good to exceptional and should get your Capital. 

Compounding –

Albert Einstein said, “Compound Interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” This concept goes both ways. Good Investments can lead to exponential growth of your assets.  Conversely, Bad Investments can fail quicker than you think, and creates magnitudes of losses.

* This also applies to so many other aspects of Life. Good Decisions can compound in the Positive direction, while Bad ones can set you back years. Good Relationships and Partners can also provide Good compounding results, where as poor associates, well you understand – See Business Rules Section and ‘Associate With’

Leverage or Financial Leverage is one of the greatest way to Multiply Wealth. In essence, it helps you Create More Wealth with Less Capital. Understanding Leverage, and when to use it properly can magnify gains. You are looking for Multipliers, types of Levers (see 80/20 under Business Rules) that propel you in a Positive trajectory.

Risk –

Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment. Quantifiably, risk is usually assessed by considering historical behaviors and outcomes.

Many Investors combat this by Diversification across Different Asset Classes. This way not all of your Investments are concentrated in one Asset class. Over the long term, Assets that appreciate are the best way to grow wealth. These include Stocks, Real Estate, CV Life Insurance, Alternative Investments, Cryptocurrency and  Commodities like Gold. Cash Flowing Businesses can be your largest and best asset.

There are two main categories for Risk – Systematic (the market, or economy) and Unsystematic (specific to a company or asset):

Types of Systematic Risk – Market, Financial, Liquidity, Political, Inflation Rate, Interest Rate, Currency

Types of Unsystematic Risk – Business, Credit, Country

Credit Capacity –

Credit Capacity is your ability to Borrow Money, aka debt or loans, which leads to Access to Capital. Lenders check the Five C’s of Credit to determine the likelihood you can repay – Capacity, Capital, Collateral, Conditions, & Character.

Whether you are running a business or have an investment opportunity, you may need cash or loans. Better to borrow $ before you need it, or establish credit lines as a backup plan. It helps to have Assets for Collateral (security put up to back the loan in case of default), or to improve your credit resume. Remember the old axom – ‘Dig the Well before you get Thirsty.’

Having access to Capital is crucial for 2 Reasons: 1. To Acquire Assets at Good Prices, and 2. To Take Advantage of Opportunities. 

Leverage or Financial Leverage is one of the greatest way to Multiply Wealth. In essence, it helps you Create More Wealth with Less Capital.  The key to using Financial Leverage, is to do this safely by using Low Risk Assets. You Borrow at a Low Rate, and Invest at a Higher Rate using OPM (other people’s money, aka – Loans). The analogy is similar to a real estate investment deal.  

Analysis –

Read, Study, Understand Real Returns –

• ROI – Return on Investment
• ROA – Return on Asset
• ROE – Return on Equity

All Investments ideas should be written down, researched and scrutinized for hours, or days. What are the chances the investment will fail? Estimate probabilities of success, and potential timelines to achieve it. What are the Market forces that could delay (or create) the return? You have to be able to explain concisely why you made the investment and what your theory is. Otherwise you are just ‘Hoping’ it will happen.

ROI (Return on Investment) is a financial metric that is widely used to measure the probability of gaining a return from an investment. It is a ratio that compares the gain or loss from an investment relative to its cost. It is as useful in evaluating the potential return from a stand-alone investment as it is in comparing returns from several investments.

Personal Financial Statement (PFS) – Fill out a PFS every year to get the full picture of your assets, and liabilities. This will keep track of your overall Net Worth, and confirm it is increasing. Keeping an updated PFS allows an individual to track how their financial health improves or deteriorates over time. These can be invaluable tools to analyze your financial situation or apply for credit such as a loan or a mortgage. Often if you take out a business loan, there may be a personal guaranty needed, and the lender will request a PFS. 

EBITDA – or earnings before interest, taxes, depreciation, and amortization, is a measure of a company’s overall financial performance and is used as an alternative to net income in some circumstances. EBITDA, however, can be misleading because it strips out the cost of capital investments like property, plant, and equipment.

This metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings. Nonetheless, it is a more precise measure of corporate performance since it is able to show earnings before the influence of accounting and financial deductions. Simply put, EBITDA is a measure of profitability. This is commonly used in Private Equity to value the whole company.

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