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Niehaus Liberty Investing, LLC Fee-Only Intelligent Investing

September 30, 2010


The economic situation remains somewhat unchanged over the past three months.  There have been a series of better than expected economic reports, but we still face a slow recovery, with some small potential for a double dip recession.  Market volatility continues at levels much higher than the norm; indeed, this past quarter was particularly volatile for small-cap and mid-cap stocks.  Investors have been cycling quickly between fear and greed, and I wouldn’t be surprised if that continues for a while longer.  Once hiring in the U.S. starts to rebound, and the recovery looks more stable, I expect volatility to ebb.    


With all that noise whirling through the markets, I have been keeping my focus on the fundamentals of the companies in your portfolio.  I thought it might be helpful to offer a snapshot of two often overlooked items buried in the financials that I keep my eyes on: cash flow and receivables.


Cash Flow: Wall Street loves a good earnings number, but a business needs cash to grow, pay down debt, and return money to shareholders.  Strong earnings growth should come with equal or stronger growth in operating cash flow (that is, earnings should generate cash).  If that's not the case, earnings numbers could be masking operational weaknesses. To check this, I subtract the company's net income from its cash flow from operations, and measure the trend.  


Receivables: Most companies book revenue before they collect cash for sales.  This shows up on the balance sheet as accounts receivable. Sudden spikes could indicate trouble collecting on bills or the use of generous payment terms to entice customers.  Higher receivables could also mean that management is recognizing revenue to artificially boost short-term results.  To see if a company is practicing good cash management, I compare revenue growth with growth of receivables.  One can also measure days sales outstanding (DSO) to see how long it takes for a company to collect on its bills. To calculate DSO, divide receivables by revenue, and multiply by the number of days in the period.  


Instead of trying to predict the future of the economy, value investors use analytical tools to select solid companies, selling for good value.  With a diversified portfolio of such companies, we expect to outpace the market in the long run.      


As always, I’m available to answer any questions you might have.  


Regards,



Aram Durphy