The World Turned Upside Down

Written by Nathan White, CFA

photo by wolfgang staudt

Cash is always king. Cash flow, cash in hand -- whatever form and in whatever economic condition.

The true value of any asset is its ability to produce cash flow -- either immediate or in the future. Why else does anyone make an investment?

Did you know that Fannie Mae and Freddie Mac have not drawn a single penny of the $200 billion that was set aside to bail them out?

Why? Because the companies are cash flow positive. In what way has their tenuous situation changed to make this possible?

Market-to-market accounting was institutional with the right idea in mind -- create more transparency of a company's assets for investors. Unfortunately, it is implemented in the wrong manner.

During good times companies are forced to mark assets up (which of course they gladly do!) and record those gains as income.

It's kind of like your neighbors who kept bragging about the appraised values of their homes during the real-estate mania as if to show one another up.

Until you actually complete a sale and get the cash in hand you never completely know what something is worth.

Any analyst worth his/her salt knows that this type of non-cash income is not really income per se, but just potential income. Remember, cash flow is king!

Companies that exhibit Strong cash flow returns over time end up being the most valuable companies in my estimation. Now companies are feeling the pernicious effects of the downside of market-to-market accounting as they are forced to market their assets down at ridiculous prices and record the loss on their capital accounts.

Why will the government bail-out plan work?

Because Washington doesn't have to play by the same rules that it makes the private market play by.

Private is frozen because investors do not want to place their money in a company that if forced by regulators to market their assets at fire-sale prices which in turn reduces their capital ratio below what the government regulates it has to be. It is a death spiral in the current environment!

In my view there is no single more important thing that can be done to stop the credit crisis than to fix the market-to-market accounting regulations and it would cost the taxpayers nothing!!

These truly are amazing times.

SO much doom and gloom and irony! It can make your head spin.

The smart money is buying - Buffet, the few smart savvy hedge funds, and I can't believe I am going to say this - the government!

There are so many quality assets on sale, but the irony is that when everyone is panicking even those assets continue to fall.

Smart investors, because they have never overextended themselves during boom times, are able to take advantage of these deals and wait out the short term volatility.

That is the irony of economic busts, deals abound but the majority do not have the capital to take advantage of it! Consider real estate, now is the time to buy and as a buyer you can negotiate some unbelievable deals, but that is only if you can a loan, which almost no one can right now. So unless you have the cash on hand it is nearly impossible to take advantage of the situation.

Well, the same is true in the capital markets right now. There are great deals on quality assets all around, but because banks aren't lending no one can buy unless they have cash.

That is why you only see people like Buffet, certain hedge funds, and the government being able to buy assets in the current environment.

Where do you stand in this environment?

Are you overextended and unable to take advantage of the bear market or are you in a sound financial position and regardless of the outcome of the current crisis (for bad or for good) you will be on a stronger financial condition than most people.

Remember, the market can stay irrational longer than you can stay solvent.

Don't bet the farm -- do it in increments.