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The following is an extract from last week's regular feature in the Personal Finance section of the Independent On Sunday. Be sure to pick up your copy this Sunday.
These days, of course, most of us can buy all the shares we want within the tax-free wrapper of a PEP or, after April, an ISA. Shares held within these tax-free wrappers are not liable for capital gains tax. Foolish Trivia I was a WW II bomber, I am the leading UK business in my field and this week I announced that I was planning to give £1.5 billion in cash back to my very happy shareholders. Who am I? My Dimmest Investment Many years ago I did three months of back-breaking work on a conveyor belt to help pay our crippling mortgage. The final day looking through the FTSE Index a company name -- Poseidon -- jumped out at me. The name stuck and wouldn't go away. The crucial question was: invest in our mortgage or buy the shares? The mortgage won. A few weeks later, Poseidon shares started to rocket and quickly went through the roof. I could have bought two houses with the proceeds of the shares. -- B.G. Oldham The Fool responds: Actually, perhaps this wasn't such a dim investment decision after all. Investing in shares should be a long-term undertaking. There are big gains to be made in short-term speculation, but even more often there are big losses. The last thing we should be doing is risking our homes on the back of a gamble, whether in the stock market or elsewhere. These shares could as easily have plummeted as rocketed in such a short time. Maybe another lesson here is not to buy "too much" house simply as an investment. In pure investment terms, property has proved a decent investment over time, but the stock market is better. And when interest rates go up -- which can seem almost inconceivable when they are as low as they are now -- that overly large mortgage rapidly becomes a millstone. Money, Money, Money... Money makes the world go round. The more you've got, the more you can potentially make. Just by leaving money in the building society, you are earning interest, and therefore increasing your wealth. Debt, on the other hand, apart from the cheaper mortgage variety, will ultimately erode your wealth. Individual companies work in a similar way to humans. They are always looking to grow, to better themselves and, importantly, to increase shareholder value. After all, they are run by humans, and these are the people who ought to benefit from a company's success. This can happen in the form of increased salaries, bonuses and, possibly, share options. Good companies make sure top management's objectives are firmly aligned with those of their paymasters -- the shareholders. The first sentence on page one of Information Technology company Misys' (MSY) 1998 annual report says, "The Group's philosophy is based on enhancing shareholder value, measured by growth and stability of long term cash flows." This succinctly encapsulates why quoted companies exist and should be at the forefront of every management's thinking. There are many ways to value a company, but over the very long term, a company is ultimately valued by the sum of its future cash flows. Shareholders investing cash into any business expect to get that cash back, and more, and at the same time be suitably rewarded for the risk they undertook when investing in the entity. That may come in the form of dividends, capital appreciation or a combination of both. One of the reasons shares in the engineering sector are so bombed out is that the companies do not generate much in the way of free cash flow. Free cash flow can be defined as cash from operating activities, less capital expenditure and taxation. It is effectively the money left over after all essential payments have been made, and it can be used to increase shareholder value. Management may choose to fulfil this goal by paying out the money in dividends, making acquisitions or buying back their own shares. Engineering companies have much of their assets tied up in expensive plant and equipment. Think of the kit that a company like British Steel (BS.) needs in order to roll out all those sheets of metal. There are the factories, machines and lorries, to name just a few things. This equipment is expensive to buy, and maintain, and needs replacing from time to time. This is cash that can't be used to grow the business, and therefore shareholder value, because it is needed just to keep the business running. To compound things even further, a company like British Steel operates in a very competitive environment and has little or no pricing power. It's therefore little wonder that the share price for this company has halved over the past four years. On the other hand, a company like Misys has a much leaner operating model. It is essentially a service company and supplies software products to the banking, insurance and healthcare markets. Once the company develops a piece of software, it can then sell that same piece of software to many different customers. The incremental cost of manufacturing is relatively small, and even this is usually outsourced to a specialist third party. Misys has very little money tied up in assets because it doesn't need expensive equipment in order to make its products. This allows the company to throw off large amounts of free cash flow, which it can then use to enhance shareholder value. In the past, Misys have done this by acquiring companies that complement their existing businesses. When looking for investment opportunities, Fools would do well to look at the company's cash generation abilities. Over the long term, this will ultimately drive shareholder returns.
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