How to Get Rich
Investor Education: Free Cash Flow
Free cash flow (FCF) is the amount of cash a company can generate after paying its operating expenses and capital expenditures. Free cash flow is essential because it shows the investor how good the company is at generating cash and if the company has enough cash to distribute a dividend or buy back shares. There are a few ways to calculate cash flow, but for simplicity, we will use operating cash flow in our method. Let’s use an example of a theoretical company called ABC Inc. ABC Inc. has $2 million in cash flow from operating activities and $1 million in capital expenditures. ABC Inc. will have a free cash flow of $1 million.
How to Get Rich
Author and professor Jared Diamond gave a talk in 1999 titled “How to Get Rich.” Given the year the talk was given, you might think that he recommended buying IPOs of all the hot technology companies, regardless of price. But no, the talk was about something different.
Diamond spoke about the things we can learn from the history of countries, companies, and people about the systems that create wealth—and those that squander it.
It’s said that progress isn’t always a straight line up. But progress also reverses course—often in dramatic fashion. When Tasmania got cut off from the Australian mainland 10,000 years ago, the 4,000 isolated individuals and their descendants that followed not only didn’t invent like their counterparts back on the mainland, but they went in reverse. The technologies they had, such as bone tools, ceased to exist in the fossil record over time until the area was rediscovered by Europeans in the 17th century.
The story of Tasmania is just one of the examples that Professor Diamond uses to make his points, which are summarized in this paragraph:
“So what this suggests is that we can extract from human history a couple of principles. First, the principle that really isolated groups are at a disadvantage, because most groups get most of their ideas and innovations from the outside. Second, I also derive the principle of intermediate fragmentation: you don't want excessive unity and you don't want excessive fragmentation; instead, you want your human society or business to be broken up into a number of groups which compete with each other but which also maintain relatively free communication with each other. And those I see as the overall principles of how to organize a business and get rich.”
From those words, you can brainstorm and imagine and hypothesize ways to apply those principles to the investing business.
On the first point: Be careful about isolating yourself. Investing is a business where it’s easy for the endowment effect, the sunk cost fallacy, and confirmation bias to lead one into mistakes of one’s own making. It’s helpful to have friends and colleagues that you trust to critique your own ideas, as well as open your eyes to new ones. In fact, Phil Fisher, in his book Common Stocks and Uncommon Profits, credits his friends and those he followed from a distance as being a key source of his investment ideas:
“This about sums up how I go about finding growth stocks. Possibly one-fifth of my first investigations start from ideas gleaned from friends in industry and four-fifths from culling what I believe are the more attractive selections of a small number of able investment men.”
And to Diamond’s second point above: Decentralization can be a major advantage. It was one of the keys for Warren Buffett in building Berkshire Hathaway, as well as other business leaders profiled in the book The Outsiders, such as Tom Murphy and Henry Singleton. There is a balance and art to finding the right amount of decentralization for a given business. But whether you’re investing in that business or building it, being involved with an organization that combines fragmentation with competition and communication can be a recipe for both long-term success and, yes, getting rich.
Tweets of the Week
In Case You Missed It…
The Meb Faber Show: Michael Mauboussin, Counterpoint Global – Everything Is a DCF Model [Related paper, which is read in the podcast episode: “Everything Is a DCF Model”]
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