Investing can be a daunting undertaking. I mean, where do you start? Even for the most experienced investors, crucial decisions such as trying to decide which companies deserve a position in your portfolio, how many businesses to own, what percentage of cash you should hold and whether or not to invest in alternative assets can prove tough to make.
That being said, the core of any investment strategy should be designed around one key desire: the desire to prevent losses.
When I say losses, I don’t mean a 2% portfolio drawdown. I’m talking about a permanent impairment of capital or putting it another way, a total loss. Taking a total loss at any point in your investment career can be hugely damaging to your long-term investing success and wealth creation.
A total loss can be catastrophic
A capital impairment of just 5% of your total portfolio in the early days can cost you tens of thousands or hundreds of thousands of pounds over the long-term. A total loss then, should be avoided at all costs.
There’s one golden rule that I have, which is designed to protect me and my portfolio from such total losses. I admit this rule won’t guarantee that I will never see any of my positions go to zero, but it will almost certainly help push me in the right direction when it comes to making investment decisions.
So what is this simple yet highly effective rule? Follow the cash.
Cash is king
It’s said that in business, cash is king and over the years I’ve found this to be not only accurate but also revealing. Cash flows are, compared to profit figures, relatively difficult to manipulate. If a company is reporting profits of say £10m, and claiming income growth of 20% yet only recorded a cash flow from operations of £500,000, it’s a red flag. There may be an entirely valid reason for the discrepancy, but such a wide gap between cash flows and profits can indicate the use of aggressive accounting.
Some of the largest corporate scandals in history were revealed because they ran out of cash despite recording large and ever-increasing profits. These scandals should act as a warning to investors to follow the cash, not the profits.
Cash on the balance sheet is another important cash metric to consider. Debt isn’t always a bad thing. If used correctly, debt invested in assets that can generate a return in excess of the cost of debt over time can accelerate business growth. However, too much debt can strangle a company and limit its options.
The economy moves in cycles and has done for hundreds of years. Therefore, it’s highly likely that any business, at some point in its life, will find itself in a tough trading environment. If the firm in question has cash to hand and little debt, coping with the downturn won’t be as difficult as a company that has a queue of creditors waiting for interest and debt payments.
All in all, the conclusion is simple. If you want to be a successful long-term investor, follow the cash.