Understanding What It Means to Invest for Cash Flow and Capital Gains
Ever wondered what it takes to become a successful long term investor?
You don’t necessarily need to have deep macro knowledge about international trends, or a gambler’s mentality. No, long term investing really comes down to your investment principles, and having the courage to stick to them.
In the investment world, there are two basic investment principles. They are:
- Investing for capital gain
- Investing for cash flow
One of the foundations for successful investing is to be clear on which principle you want to follow. It’s advisable to choose one as your main principle even if you end up doing a bit of the other along the line. If you decide to go in just any direction at any point in time, chances are you’ll end up being confused – and frustrated.
If for no other reason, the one reason why you want to have an investing principle is to help you measure your success.
I should make it clear that, contrary to what you might have read in the past, cash flow investing isn’t superior to capital gains investing – nor vice-versa. It all depends on what you want to achieve in the end. Let’s consider these investing principles one by one.Capital Gains Investing
At its heart, capital gains investing is the art of buying and selling an asset for a profit. For instance, you are a capital gains investor if you buy a stock for $100 a share and sell at $150 a share. This means that being successful at capital gains investing fundamentally hinges on your ability to identify undervalued assets.
People often mistake capital gains investing for the game of speculating on assets. While there is a risk of speculation when investing for capital gains, this investing principle isn’t about speculating. Successful capital gains investors don’t buy and “pray” that the asset just appreciates, as many antagonists of this investing principle describe it. Capital gains investing is a principle of buying below retail value and waiting for the asset to rise (its stage of maturity). It’s not the game of buying at, or even above, retail price and hoping that inflation will occur to make a profit. The latter is speculating while the former is investing. Investors who invest for capital gains research assets to be sure they are trading below their intrinsic value.
A good way to see capital gains investing is by seeing yourself as a value investor. Value investors look at certain aspects of an asset to determine the asset presents an upside potential.
If you’re going to invest for capital gains, the first thing you want to do is to research an asset to make sure that it’s not already overpriced. You have to put down some criteria for anything you want to invest in. We’ll consider two instances, one for stocks and the other for real estate, to establish a proper capital gains investing discipline.Instance 1: Investing in Stocks
Note: This example isn’t to recommend any mentioned stock, and I do not own shares of any mentioned stock.
Since the stock market is made up of various industries, the first thing I recommend is to only invest in the industries you understand well. Investing in industries you don’t know is the first step to becoming a speculator, as your investment decisions won’t be adequately informed. On the flip side, when you invest in industries you understand, you can easily tell when a company is doing something that presents an investment opportunity.
Having said that, let’s consider some investments that target capital appreciation.
Let’s say that in 2007, when Steve Jobs unveiled the iPhone, you predicted Apple would change the mobile phone landscape. So, you bought Apple stocks with some level of certainty that its price would rise in future. In reality, when the iPhone finally delivered on that promise, Apple stock rose.
Now let’s say that when Google came out with Android, based on your research you determined Apple could no longer dominate the mobile phone market. So, you decided to cash in at a profit. You wouldn’t if you found something new in Apple that promised an even greater upside potential.Instance 2: Investing in Real Estate
As a capital gains investor who wants to invest in real estate, you have to lay down some real reasons why you want to invest in any property. Whatever the reasons are, there must be an upside potential. You can’t just buy a property because there is an in-built theory in real estate investing that properties will always appreciate. Again, that would mean you’re speculating on the property.
Here is a good instance of proper capital gains investing in real estate. You might set your discipline as investing in properties in regions that could see significant urbanization over the next few to several years. For instance, if you have reliable information that a higher institution will be established in an environment that is relatively under-urbanized, you might decide to take positions in properties in that environment knowing that, when the institution arrives, the value of the properties will rise.
You’ll notice that, in the two examples, the key strategy is buying when an asset is undervalued and selling when it’s no longer fairly priced, or better yet, overpriced.Capital Gains Investing Best Practices
As I stated above, it’s easy to speculate when you invest for capital gains. However, if capital gains investing is your favorite path, consider the following as part of your discipline:
Cash Flow Investing
- First, don’t sell just because an asset you bought at $100 is now $150. Your reason for selling should be that, at whatever price it is, the asset no longer holds the criteria which motivated you to buy in the first place. While you may lose at times, if you had a reason that’s beyond metrics, you will win in most situations.
- Don’t sell because the market is down. For instance, if you bought Apple in 2007 because it would dominate the mobile market, chances are you were tempted to sell and get some profit when the market went down in 2008. That would be a wrong call, since the market crash didn’t make Apple lose its position in the mobile market. You should always keep in mind the market always fixes itself somehow.
- Don’t speculate. No matter how much analysts talk up any asset, you need to be sure that it meets your investment discipline before you take any position. You have to be sure that it is really undervalued. Anything other than that is called speculating.
- Research a lot, buy a little. If you’re going to be successful at capital gains investing, you have to spend more time researching than investing. If you conduct your research diligently, you will always find out that only about 10% of the assets you research are worth investing in. But don’t be tempted to invest because of the time you have invested.
- This is not really a “best practices point,” but it’s worth mentioning. If you’re going to invest for capital gains, you should ensure you have a positive cash flow. As stated above, capital gains investing requires diligence and patience. If you don’t have a positive cash flow, it is easy to foul on your discipline and speculate instead of doing everything stated above.
Simply put, cash flow investing is the art of purchasing an asset and holding onto it in expectation of getting a constant return on a monthly, quarterly, or even annual basis. Regardless of the interval, the keyword here is a “constant return on your investment.”
The periodic return usually takes the form of dividends for certain investment vehicles like equities, or it could come in form of rent in real estate investing. The core idea of investing for cash flow is to build wealth steadily. This investing principle is what gurus would tell you to use to prepare for retirement.
This model is also good for building capital, as it assures you of a constant income at intervals. The reason why investing gurus advise people to invest for cash flow is that it helps people keep their eyes off short-term market movement, which could lead into panicking.
With cash flow investing, you aren’t caught up in the risk of estimating too much. I must state at this point that, as shown by various researchers, if capital gains investing is done right, it promises better return than investing for cash flow. In fact, as Geoff Considine found, income investing reduces safe withdrawal rates.
However, investing for capital gains comes with a somewhat higher estimation risk. Since you’re after capital appreciation, it is easy to overestimate the investment opportunity at hand. But with cash flow investing, you won’t have to do much estimation since what you’re after is steady income.
Another reason why income investing could be potentially safer than capital gains investing is that it doesn’t depend very much on your ability to time the market.Strategy Still Matters
Cash flow investing isn’t all about just putting your money into some income-generating assets. You will need to have a strategy. First, you should always take the long-term view. You have to research the potential state of an asset (real estate or securities) for years to come. At the minimum, even if the asset will have a problem in the future, you need to be certain to some extent that the asset would have generated enough cash flow to cover your initial investment. Again, here are two instances to understand the proper way to invest for capital gains.Instance 1: Investing in Stocks
You can’t afford to invest in a dividend-paying stock just because it pays well at the moment. You need to conduct research to have some level of certainty that the company behind the stock has the potential to, first and foremost, sustain its business at a level where it can keep distributing its gains among investors at intervals.
It’s of great importance to know that lethargic economic growth and depressed earnings forecasts, among other factors, could make companies cut their dividend payout or even completely stop paying dividends.
When investing in stocks for income, you need to be aware that the most important thing is the ability of the company in question to maintain a huge cash reserve. It is from cash reserves that companies pay dividends. If, for instance, you want to invest in Microsoft, you want to be sure that the company can generate and maintain a huge cash reserve.
An effective way to assess a company’s cash-generating power is by looking at its businesses. You want to check how diversified the company is. You have to check the company’s position in the markets in which it operates. One thing I have found with the most-performing dividend stocks is that they are leaders – not necessarily number one – in their industries.
In the case of Microsoft, the company is a leader in the PC market, and it is also well diversified. It also generates sufficient free cash flow from its businesses. As long as the company leads the PC market and remains diversified enough to keep generating a healthy cash reserve, it would be a good option for generating income. Without these fundamentals, investing in Microsoft just because it pays dividends will be risky.Instance 2: Investing in Real Estate
Again, you can’t afford to invest in any property just because the income is great at the moment. You also need to be sure that the properties you invest in can perform long enough for you to recoup your initial capital.
When investing in real estate for cash flow, you have to think about things like this: What future events could cut me from this stream of income? Earthquakes or any natural disaster? Civil unrest? And then, you have to research into the possibilities of these events occurring. This will help you make safe and informed decisions.
For instance, a good practice would be to invest in properties in areas that are usually peaceful. Such areas will naturally attract residents, which will assure you of a consistent – and perhaps growing – income from rentals. However, if you invest in some property in a volatile area just because it generates high income at the moment, you are exposing yourself to significant risk, as such an environment might end up being unsafe to inhabit and end up forcing income down due to decrease in property demands.
As a matter of fact, you might want to follow the approach I described in capital gains investing. Invest in any asset because you see value in it. This approach, while it may not promise the highest yield, gives some assurance that your invested capital will be safe, whilst you generate income.Cash Flow Investing Best Practices
A Big Misconception
- History matters. This might be counterintuitive since some gurus say that the past doesn’t determine the future. Yes, they’re right. But the truth is that the more we hear such things, the more we find history repeats itself. Even after you’re sure that the asset you’re investing is great, you need to look at its history to see what it’s been building. If nothing else, be sure that the company has traces of consistently maintaining good cash reserve.
- It’s not always about yield. It’s easy to be tempted to buy an asset simply because its yield is high. However, you need to ask yourself if the high yield can be maintained. You’re better off with a low-income asset that’s consistent than a high-yield one that cannot be maintained. After all, income investing is all about consistency.
- Debt matters. When you’re investing for cash flow, you want to be sure that you’re investing in assets that don’t have huge debt on them. It’s even better to invest in assets that have no debt at all. Understand that debt will reduce your earning power.
- Payout ratio also matters. This is to tell you what portion of the generated cash is used in paying dividends. A low payout ratio combined with a healthy yield signifies that dividends are being paid easily, and that it could rise in future.
One of the biggest misconceptions about income investing is that it’s all about buying and holding. While you shouldn’t focus on short-term market movements which, by the way, isn’t even advisable for capital gains investing either, you need to keep tabs on the fundamentals of your investments. No matter how attractive an income-generating asset could be at the moment, you would be right to cash in and look for better options if the fundamentals are no longer there.How to Determine the Path You Should Take
There is no one-model-fits-all approach here, but beginner investors are better off investing for cash flow — at least until they have a positive cash flow and can manage their emotions and expectations. An in-depth understanding of markets is required to make it in capital gains investing.
In addition, if you’re planning for retirement – a relatively modest one at that – cash flow investing could be better suited for you since it guarantees a constant income.
Capital gains investing, on the other hand, is better suited for you if you already have a constant flow of income – like salary – and you’re not preparing for retirement. A constant flow of income will help you stick to your investing disciplines no matter what. However, you need to be able to stomach more risk if you’re going to invest for capital gains.