During Uncertain Times, Screen for Companies with “Cash King Margins”
By Tom Cleveland 2012-01-27When the seasons are about to change and times ahead are filled with uncertainty, you may often see industrial squirrels stockpiling acorns away in every location imaginable. Experienced companies are no different than these little rodents, except that instead of nuts, they pile up cash on their respective balance sheets, preparing for whatever might come along when the direction of the business cycle is in doubt.
For the industrious investor, the objective then becomes how to screen for cash “heavyweights”, if you believe that this cash value may inure to your benefit down the road in the form of higher dividends, appreciating share values, or increasing percent of ownership due to stock buyback programs. Companies with high cash balances are also more likely to pursue acquisitions at bargain prices before an economic recovery provides a payoff down the line.
The financial press has sounded like a broken record for the past few years, proclaiming that over two trillion dollars in cash has been “hoarded” on corporate balance sheets, but how does one screen for companies where cash translates to future potential? The key variable of your search will be what has been nicknamed the “Cash King Margin”, which is computed by dividing the annual “Free Cash Flow” figure by sales revenues. If this figure trends in a positive fashion above 10%, then the compounding effects over time can only mean better prospects for you and your investment holdings.
The place to begin is with “Free Cash Flow”, and here is a brief definition: “Free Cash Flow (“FCF”) is the amount of cash a company has after expenses, debt service, capital expenditures, and dividends. Free cash flow, which is measured at least annually, suggests the financial comfort level of the company as a going concern. The higher the free cash flow, the stronger the company’s value will be.”
Creative accounting techniques have clouded the quality of many corporate earning statements, but investors have always been able to trust cash as being the ultimate scorecard of success. Blue Chip companies have regularly been cited for their safety and soundness, especially during times of uncertainty. One reason is that their “Cash King Margin” often exceeds 20%. As for companies that exceed the 10% benchmark, Time Warner Cable is often the example used to demonstrate this principle. Over the past four years, their ratio has trended positively from 9.1%, 9.3%, 11.1%, and then to 15.5%, an impressive track record during very tough times.
Of the $2 trillion figure often quoted, nearly half of that amount is in overseas bank accounts. You do not have to have a forex account and have an interest in currency trading to understand that these amounts are denominated in currencies other than the dollar. The companies that comprise the S&P 500 index earn over half of their revenues from operations overseas, and treasurers often take advantage of tax rules that defer taxes on some of these funds until they are actually repatriated to the U.S. This fact, however, has led to additional returns as our dollar weakened during the Fed’s “QE2” program. Plans for “QE3” are being readied in case Europe stalls the current global economic recovery. Another round of dollar dilution will also be favorable for foreign funds.
Using the “Cash King Margin” may help you locate a few interesting prospects for your portfolio considerations. You may find that a majority of your selections are small companies that reinvest their free cash flow back into the company. This “peculiarity” may not be a bad thing since big oaks from little acorns grow.