You must be positively negative

Ah the dreaded bye week. Those of us here in Pittsburgh have come to loathe a weekend away from the Steeler football season. After all, what else is there to do on a Sunday afternoon after church and brunch besides watch football?

Glad you asked! We can talk about positive and negative coorelation and how it relates to your portfolio of stocks and investments, of course!

Let me start with a simple illustration. How many of you are married? Oops. I forgot that I can't see if you're raising your hand or not, but I can tell you this. For those of you that are married, I'm fairly certain that you and your significant other don't often see eye to eye on what to do during the dreaded bye week. Am I right?

After all, some of us (myself included) are excited that we can still watch Brett Favre throw a couple of zingers or the Colts play someone, etc. Football doesn't stop just because (gasp) the Steelers aren't playing.

Others (usually the other half of the married couple) find this a perfect excuse to head to the shopping outlets, meet aunt Ethel for a late lunch, shop some more and basically avoid the television set at all costs.

Hmph... a dilemma here for our married couple, isn't it? Well, not really.

This couple has (in investment terminology) a "NEGATIVE" coorelation. They are moving in opposite directions, and while it might not be a good thing at the time, it has great long term ramifications that are a good thing. For instance, the husband may compromise and shop for a while, so long as they can stop at the Quaker Steak and Lube for the 4 o'clock game and some wings. Both parties win out by meeting in the middle. This compromise is what eventually makes the marriage stronger, the bonds thicker and the relationship great.

The newlyweds, however, cave to each other and try to do whatever the other wants, right? This is called "POSITIVE" coorelation, and it can be deadly; not just to the strength of the marriage, but to a portfolio of stocks.

Huh? How does this relate to stocks?

Think of it like this. If you had a portfolio of stocks that had Microsoft, Dell, Gateway and Hewlitt Packard, how would all of them react to a slowdown in the economy? Well, since they're all technology stocks, all would likely respond the same way. This is just like the newlyweds reacting the same way to every issue. POSITIVE COORELATION is very bad for a portfolio.

Now think of a portfolio that has MSFT, Exxon, Pfizer and Wells Fargo. All four of these stocks are in different industries (software, oil, pharmaceuticals and banking) so all four might react differently given the same economic conditions such as an oil crisis, recession, war or market meltdown. This is NEGATIVE COORELATION and something we desperately want for our portfolio. In fact, we strive to acheive total negative coorelation in portfolios (at least the eggheads running our mutual funds do, anyway.)

We can then either OVERWEIGHT or UNDERWEIGHT our portfolio while still maintaining negative coorelation. For instance, you might really think that the oil industry is set to boom, so you can own more shares of Exxon while at the same time, still own Microsoft, Pfizer and Wells Fargo. This is what CFA (Chartered Financial Analysts) do on a daily basis to ensure diversification and negative coorelation for their clients.

With all this said, it would be unfair to NOT mention the recent pummeling the market has taken in the past two weeks. However, with proper BETA weighting, portfolio diversification and patience, I can tell you that I believe there is light at the end of the tunnel - although the Feds had nothing to do with this.

It is my best guess that there is another six to nine months of market jitters remaining, but we are through the worst at this point in time. As soon as consumer confidence rebounds (again, my opinion, but when gas prices drop below $3.00 per gallon nationwide) and we have a president elected, things will come back. It is going to be a slow, methodical climb out, but one worth watching.

I would also suggest that we are near some historic price lows for some very strong companies that have been dragged down by the market, such as GE, Pfizer, Coca Cola and Altria (Phillip Morris.) These are companies with strong fundamentals, good balance sheets and solid products that traditionally can survive a recession. I do not currently own any of the companies listed, but I plan to very shortly.

Well, the 4 o'clock game is on now (we compromised today) and that's all for now.

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Finding the Perfect Balance

Okay, I confess.

This is a misleading title intended to draw in you readers that are opposed to doing hard numbers and would rather focus on the soft sciences of psychology, marketing, etc.

Gotcha!

The perfect balance I am referring to is the Balance Sheet. This simple, usually one-page document gives a snapshot of any given business at one point in time - typically at the end of the month of a business quarter/cycle.

The beauty with the balance sheet, though, is that while tiny in size, it is a magnifying glass to everything goin on within the business itself.

Remember, the left side has to equal the right side! As a result, the assets (left side) are equal to liabilities (debt) + capital (owner's equity.) Whew. That was hard.

Take a look at the one below:

Weeklybusinesstips

June 8, 2008

Assets Liabilities

Cash $50,000 Short-term Debt $30,000

Accounts Rec $40,000 Accounts Payable $50,000

Merchandies/ Salaries $110,000

Inventory $100,000 Total Current Liabilities $190,000

Total Current

Assets $190,000 Long-term Debt $20,000

Plant/Equip $30,000

Accumulated

Depreciation (2000) Owner Equity $8000

Total Assets $218,000 Total Liability/Equity $218,000

Yes, I know it's exciting to read a balance sheet on a blog; especially one as basic as this. But the ramifications from the balance sheet are enormous, and our understanding of the business grows tremendously once we begin to dig into the balance sheet and discover that things exist there.

First, and foremost, is notice that the assets are listed from most liquid to least liquid.

Why is this the case?

As business owners, I don't need to tell you that cash is king. It's the most easily understood, and universally accepted, forms of payment. You don't need to process anything more than a receipt and the corresponding deposit slip, as the bank accepts these funds the instant they hit your account.

Account receivable, on the other hand, are from your credit paying customers. Aside from the credit card comany taking their 2-3.5% fee on each transaction from you, there is always the risk of the purchase being disputed by the customer, and the processing time takes a few more days. Thus, AR is not as liquid as cash.

Finally, inventory is listed as a current asset and considered the least liquid. This is the result of fluctuations in the business cycle and an ever-changing consumer demand for your product. Additionally, your accounting method will need to be considered for the balance sheet, as the price you paid two weeks ago to make your product may be higher or lower than when you purchased the materials. FIFO and LIFO are important elements to consider for this entry.

On the liability side, the same science is applied, using short term debts and accounts payable as the most necessary payments, followed by longer-term liabilities.

So you don't need to be a rocket scientist to realize that if you reduce your liabilities, a.k.a. - costs, expenditures, debts, etc. and your assets stay the same, your owners equity has to increase in order to balance the account! That's why costs are so important with what we do.

Imagine how great this balance sheet would improve if we simply cut our accounts payable by 20% to a total of $40,000. The owners equity would increase from $8000 to $18,000! And that doesn't even factor the possibility of increasing cash balances with increased sales or higher prices.

A few final thoughts on the balance sheet.

1. It is not wise to skip over a balance sheet. While elementary in scope, that is intentional. The balance sheet is intended to be the glossary for accompanying financial statements such as the income statement, statement of cash flows, profit and loss statement, etc.

2. The balance sheet is a snapshot of one day in time! Keep it consistent and monitor your balance sheet frequently. If not daily, at least weekly, and make it the same time each week. For instance if you have large sales on the weekend, get a Monday morning balance sheet.

3. Pay attention to variables within your business that fall into categories that can jeopardize your equity position on the balance sheet, such as accounts receivable and accounts payable. While it might increase sales in the short-run, relaxing credit standards to sell more items is seldom a wise move for the long-haul. Similarly, review your vendor accounts frequently and push for better terms as your performance paying the accounts improve. For example, you may have a perfect record paying within 30 days to all of your vendors. Go back and ask for a reduced bill if you pay in full within 15 or 20 days, such as a 2/15 net 30 (this means a 2% reduced bill if you pay it within 15 days, or just full payment if you pay after 15 but before 30 days.) Most vendors will work with you so long as your credit history with them is positive.

4. Don't dwell over the numbers! It's too easy to become bogged down and get frustrated when things don't turn your way on the balance sheet. We will later discuss how to improve cash flows, so just be cognizant of your balance sheets and find ways to make minor modifications to your business process that result in increased cash balances, reduced inventories and lower costs.

Please send your questions and/or comments to me anytime! I'd love to know that you're reading and enjoying.