"I gave myself a rule: if I cannot understand what he or she says, then it's not the right person for me. I'm the client, and I need to understand.” Riccardo Grabbio
Financial advisors, attorneys, doctors, and fiscal consultants are essential professionals who help us navigate an ocean of information to make sound decisions. How do you choose a good one when the language they speak is a nebulous lingo few people fully understand?
Riccardo Grabbio is a seasoned financial consultant known for his pragmatic approach and extensive experience as Chief Financial Officer. In this episode, Riccardo helps clarify some common financial lingo so you can build trustworthy and clear communication with your financial advisor or find the perfect one you understand.
Stephen Matini: If I'm someone with limited knowledge about finance, seeking a financial advisor, where would you recommend I start?
Riccardo Grabbio: When delving into the realm of finance, it's not a small or narrow subject. There are numerous aspects to consider. So, the initial question is, ask yourself, what do I need? For example, in personal finance, you might need to establish a budget to gain control over your expenses.
Another option could be engaging a financial advisor. This might be necessary if your company needs improvement, either due to an insufficient balance between revenues and costs or because you're not effectively managing your working capital. It could also be the case that, despite generating revenue, your cash flow is not as expected, and you're unsure why.
Alternatively, you may find yourself with a surplus of cash but struggle to leverage it effectively for the growth of your company. Or, perhaps, you have a personal heritage that you want to yield better returns.
Currently, I find myself in a situation that is quite common among Italian families. To illustrate, it's important to note that Italy's GDP growth is not satisfactory, largely due to inefficiencies, weak industries, various tax issues and remarkable red tape. Despite these challenges, Italian families tend to be relatively affluent. They possess substantial cash reserves accumulated over generations and own significant properties.
One notable issue I've observed in Italy is the phenomenon described by Americans as being "asset-rich and income-poor." For a financial advisor like me, addressing this situation is paramount. The goal is to change this status because when you find yourself in a position of having substantial assets but insufficient income, it indicates inefficiency or a lack of effective asset management.
In such cases, a financial advisor can bring significant value. Consider a wealthy family with a well-established family office versus the same wealthy family without proper financial management. The outcomes would be vastly different, highlighting the transformative role a financial advisor can play in optimizing financial situations.
SM: You highlighted the importance of cash flow. Can you explain why this is crucial in the realm of finance? And why do you emphasize the significance of time in financial investments, considering it's more crucial than the immediate percentage gains?
RG: Yes, exactly. Let me emphasize the importance of time, a critical factor in investing. Over the years, I've come across various studies, not only from JP Morgan but also from other sources like Banger and others. These studies consistently highlight a compelling insight. Over at least 20 years, among a group of 100% investors in the stock market, not a single one incurred a loss.
This implies that if you adopt a buy-and-hold strategy for 20 years, you're unlikely to lose money. On the contrary, if you attempt to time the market—engage in frequent buying and selling—things become more complex. Allow me to share an example. Have you heard of Peter Lynch? During his seven-year tenure managing the Magellan fund, he achieved the remarkable feat of doubling the S&P 500 every single year.
Now, consider this: we are still discussing his outstanding performance, and here's the interesting part. Despite Lynch's stellar track record, 90% of investors in his fund ended up losing money. How is this possible? The key lies in their approach—they weren't following a buy-and-hold strategy. Instead, they engaged in frequent buying and selling, attempting to time the market to catch the optimal moments to enter or exit the fund. Unfortunately, this strategy resulted in missing out on the best returns in the market. Therefore, the advice here is clear: adopting a buy-and-hold approach is prudent.
SM: Can you define key financial terms for our listeners, starting with the simplest explanation of assets?
RG: An asset is something that adds money to your pocket, while on the flip side, you have liabilities, which take money out of your pocket. Why do I mention this? Consider, for example, having a new, expensive car. From an accounting perspective, this is classified as an asset. You record it in your balance sheet, depreciating it over 10 years, and so forth.
Technically, it's an asset. However, in my view, it's not a financial asset because it doesn't bring any value; instead, it drains money from your pocket.
To simplify for our listeners: an asset is when you purchase something that will generate additional money in your pocket.
If it doesn't achieve this, then it's not truly an asset. Some assets inherently produce value. Let me provide an example: a stock index or an individual stock. Companies and their people work collectively towards a common goal of creating earnings and more. Regardless of short-term price fluctuations, these entities tend to increase in value over time due to their consistent earnings and dividend payments.
On the other hand, some assets possess value but don't generate anything. Take precious metals like gold, for instance; it's a valuable metal with a role in an investment portfolio, yet it doesn't produce anything. In this case, we are more in the realm of speculation, with uncertain future price movements. Another type of asset includes bonds. While their returns are typically low, they involve lending money to a government or a private entity, earning interest in return—a clear example of an asset that adds money to your pocket.
Real estate is yet another category of assets. You can buy flats or apartments, rent them out, and receive payments from tenants as a return. These, too, are examples of assets in the financial landscape.
SM: Can you explain P&L in super simple terms for our audience?
RG: The fundamental difference lies in the simple contrast between revenues and costs associated. This applies whether you are an individual or a company. The crux is the difference between revenues and costs. What surprises me is that many organizations, entrepreneurs, and individuals fail to grasp why they aren't generating profits. The conclusion is straightforward: either increase your revenues, decrease your costs, or do both.
Returning to the initial principle of keeping things simple, you might have a Profit and Loss statement stretching a kilometer long, filled with a myriad of detailed lines. However, when viewed from a distance of 1000 kilometers or the moon, the essence boils down to two things: revenues and costs. It may seem overly simple or trivial, but believe me, nine out of ten times, people focus on the trees without seeing the wood. When you take a distant perspective, you'll realize that it's either about increasing revenues or reducing costs. You're either one or the other.
SM: How would you define the term cash flow?
RG: Cash flow is the disparity between the money you have at the beginning of the year and the money you possess at the end of the year. The gap between these two points represents the cash you've generated. However, it's crucial to note that the cash generated is not perfectly aligned with the earnings you made in that particular year. It's entirely plausible that in a given year, you achieve substantial earnings, yet your cash flow isn't impressive because of the mismanagement of your working capital, as mentioned earlier.
On the flip side, the reverse scenario is also possible. You might experience a year with positive cash flow, but the earnings may not meet your satisfaction. This situation could arise, for instance, if you liquidate a significant asset, resulting in a substantial cash influx into your bank account. While this may seem favorable at first glance, a closer look at your Profit and Loss statement (P&L) may reveal that your business isn't as profitable as it should be. In essence, we've defined what cash flow is, but it's important to understand that it doesn't equate one-to-one with your business earnings.
SM: In simple terms, would you say that cash flow is the money left in the banking account after settling all business expenses and taxes?
RG: No, it's not the money required to operate your business; we refer to this as short-term debt, constituting your financial position. To simplify, even in a classroom setting, Steven, when you examine your balance sheet, understand that your business financing boils down to two basic methods. It might seem a bit complex, but it can be simplified: financing comes either from the equity the owner invests in the company or by borrowing money from banks or financial institutions. Despite various other methods existing, for simplicity's sake, focus on these two: equity and borrowing.
On the right side of your balance sheet, you'll find only these two components—your financial debts and your equity, nothing else. These represent the means through which you sustain your business. However, it's crucial to distinguish this from cash flow. Cash flow is the variation in your cash from one point to another.
Let me illustrate. If on the first day of 2024, you have $10,000 in your bank account, and by the end of the year, it grows to $20,000, your cash flow for the year is $10,000—the difference between the end and the beginning. This is what you've generated; this is your cash flow. On the other hand, your financial position, crucial for keeping your business operational, involves your short-term debt, representing the position recorded in your balance sheet.
SM: In your opinion, is cash flow the most important?
RG: It is, and I have a specific example of a company seen lately. They couldn't comprehend why the cash flow wasn't materializing. Looking at their Profit and Loss (P&L) statement, the picture seemed rosy – high revenues, low costs, very profitable. The margins were excellent, and volumes were on the rise. However, the cash flow wasn't aligning. The answer, though, was rather straightforward. Cash flow doesn't merely stem from the P&L's revenues minus costs; there's more to it, involving the balance sheet and working capital.
Let me illustrate with a simple example. Imagine your earnings are substantial every year, but you struggle to collect payments from your customers due to poor credit management. You might have sold numerous products to a financially troubled customer who can't settle the dues for a year or more. This scenario creates a cash problem.
Another example could be having a stellar P&L, but your inventory keeps growing, with items sitting in stock without reaching customers. Financing these unsold items absorbs cash, presenting another challenge. Alternatively, if your P&L is strong, but you pay your vendors too quickly compared to the timing of collecting cash and managing stock, cash issues arise. Additionally, investments that don't reflect in your P&L can still impact cash flow. Significant investments that don't yield a good return can create cash problems.
Lastly, there's the matter of a robust balance sheet. If your working capital is 10, but your short-term debt is 12, you face a shortfall of 2. This means you have to pay 12 in the short term to banks or investors, but your incoming cash will only be 10, leaving you short on cash. Hence, a sturdy balance sheet is crucial. There can be various reasons, but the challenge for non-finance individuals lies in connecting earnings from the P&L to cash flow.
Helping them understand that between earnings and generated cash flow, several factors need attention is essential. Being profitable doesn't guarantee generating cash.
SM: Do you stress the importance of not keeping money under the mattress and instead investing it?
RG: Yes. The second scenario is a bit different because currently, the interest rates are rather high, exceeding 4% as of December 2023. They are relatively steep. In this situation, it might make sense to consider paying off debts if you have the available cash or liquidity. However, let's reflect on the situation two years ago when interest rates were at zero, and the stock market was yielding six or 7%. During that period, it would have made sense to borrow extensively because you were essentially borrowing for free, and the returns on your invested money were at 7%. The decision depends significantly on the market situation. Generally, it's not advisable to keep your money stashed under the mattress.
SM: Based on your journey and the mistakes you've learned from, can you share three essential features to seek in a financial advisor?
RG: To me, the first thing a financial advisor must have is a good track record. Let me say that the market is something monitored and studied for 120 years, and what has been observed is that nobody has completely understood it yet. There are always new situations and black swans showing up. So, to me, the more experienced the financial advisor is, the more time they have spent in the market, the more trustworthy they become. It is not the only rule, but you need to know the market very well. So, a long time in the market with a good track record is one feature that you need to look at.
Then there is a second feature, which, of course, is very important – having a good rapport with that person. It seems not fundamental, but it is because that person will help you with very sensitive topics. They'll guide you on things that are rather dear to you in the end because they are discussing your finances and so on. So, if you don't have a good feeling if you don't have full trust in that person, I think they are not the right person for you.
SM: How does having financial stability affect your overall sense of peace and happiness?
RG: There's one thing to emphasize—when a family or an individual experiences financial stress, it becomes crucial to address it. Financial stress is, in my opinion, one of the worst situations one can face. I can tell you one thing: this is precisely why having a good financial planner is essential. Their role goes beyond managing the markets effectively; they also help you navigate the psychological impacts stemming from market fluctuations.
If you are highly knowledgeable about the market and its workings, you may not feel the same impact. However, for beginners or those who lack trust in the situation or their financial advisor, experiencing a 30% downturn in the market, which can happen from time to time, can lead to negative emotions and sleepless nights. In such situations, the role of a financial advisor becomes fundamental.
SM: How do you feel about anything that has to do with ESG investing, anything about sustainability?
RG: The first point revolves around the tactical situation. In portfolios that I manage, clients often express the desire to invest in companies known for their ethical practices and environmental consciousness. This choice makes them feel better, as they believe they are contributing positively to the environment. However, the reality beneath these companies needs scrutiny because, when investing in an ESG (Environmental, Social, and Governance) fund, for example, we can't be entirely sure if all the companies within it uphold the expected standards. Having worked closely with companies, I've observed instances where, while they might have ESG certifications and white certificates, energy usage could have been managed more efficiently, indicating environmental inefficiencies.
I acknowledge that it's commendable to prioritize doing good for the environment, a cause I am personally passionate about. Still, there's uncertainty about whether these choices are the absolute best. We hope for the best, but certainty eludes us in this aspect. This brings us to the second point: we mustn't forget that, fundamentally, investments are made to generate returns. While doing good for the environment is crucial, the primary reason for investing is to yield returns.
I've conducted a comparative analysis of the S&P 500 and ESG funds over a decade, and what I've observed is that, in the long run, the returns have been very close. At least, as of now, there isn't a substantial difference. Therefore, purely from a yield standpoint, the returns are quite comparable. The true differentiator in long-term returns lies in the asset allocation strategy.
SM: What would you say are the correct attributes a good finance person should have to enter this job?
RG: I would say, more than being possible, having the right mindset is crucial in finance. It is key from several standpoints. While possessing a good background is a prerequisite without which you cannot progress, having the right mindset is equally important. Having the right mindset means trusting your viewpoint, maintaining steadiness, and consistency in your choices, avoiding frequent strategy changes, being methodical, and staying focused on your goals. It's about navigating with a clear direction because, as in finance, seasons change, just like in the natural world. There are ups and downs, similar to the changing seasons throughout the year. You need to anticipate that, no matter what, after a downturn, an upswing will follow. It's like the cycle of seasons – after winter, spring inevitably arrives.
In finance, after a recession, sooner or later, new growth will emerge. This is precisely why having the right mindset, trusting your knowledge, staying the course, and avoiding constant strategy changes are crucial. If you alter strategies based on the current season without knowing when the financial climate will shift, you risk carrying an umbrella only to find the sun shining two minutes later, rendering the umbrella unnecessary.
SM: Out of anything we have covered, what would you say is something that those who are listening should pay close attention to?
RG: If we are discussing private investors, simplicity is key. They should strive to comprehend their actions because, as you mentioned earlier, investing in something not understood is not a wise decision. In essence, they should exercise caution. If the nature of their investment is unclear, regardless of the circumstances, refraining from investing is the best course of action.
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