Martin D. Sass, age 67, is chairman of MD Sass, which invests $7 billion mostly via separately managed accounts. He analyzes stocks as if every company could be adding water to its oil tanks. (The analogy relates to a notorious salad oil scandal in 1963 when a company was found storing water in a New Jersey tank farm that supposedly housed soybean oil.) We’re not talking about fraud but the difference between reported earnings and cash generation. Investors, he says, get too fixated on the reported earnings. Sometimes, the cash generation is worse than the earnings. Sometimes it’s better. Case in point: Computer game firm Activision Blizzard reported a net of $113 million in one year. But it did better than that. It took in an additional $300 million, mostly for subscriptions to online multiplayer games. It gets the cash now but records the revenue only over time, as the subscriptions run out. Sass owns $40 million of this stock. “I am religious about cash flow,” says Sass, who worked in his father’s Brooklyn hardware store as a kid. “To me, it’s the most important number.” Sass likes companies trading at low multiples of their free cash flow—low, that is, in relation to rivals or to the same company in past years. Sass is hoping to cash in on the ongoing deterioration of municipal finances. He owns Penn National Gaming and International Gaming Technology, both of which he figures will see increasing orders as state and local governments look to casinos to raise revenue. Penn National trades at eight times free cash flow.

1. What useful message might Sass’s investment strategy of looking at cash flow have for practicing managers?

2. When Activision Blizzard receives a payment for a subscription, why shouldn’t management report that subscription fee as income right away?

3. What do you think of the ethics of Sass investing in casinos?

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