Beware Of Cash Bloat: More Is Not Always Better

by: Chet Zaluga

Summary

Analysts often treat a company's cash hoard as if it were a bonus which costs the investors nothing. But this is far from the truth.

The cash hoard is not secret, so other investors have already taken it into consideration.

Excessive free cash tempts management to make poor acquisitions or do empire building.

Calculate the company's ideal cash reserve before making an investment decision.

Avoid stocks of companies with unnecessarily large cash reserves.

When deciding upon a fair entry price for a stock, analysts often look at the company's cash on hand and subtract it from the stock price. Their theory is that the lowered price is the real cost of the business; since the cash is a hard and fast asset, it will help support the price of the stock and would somehow be returned to the investor if the company were to be liquidated.

The problem with this thinking is that you, the investor, will still have to pay full price for the stock. The portion of the price that represents the cash on hand will be unavailable to you unless you decide to liberate it by selling the stock - which would defeat the purpose of investing.

The absolute amount of cash by itself means little. The analysis must look to the scale of the business and the extent of the need for cash for ongoing operations and upcoming liabilities. Some industries are capital-intensive with low margins, and huge amounts of cash may be needed for bare survival. Others, such as software and services, can achieve a high ratio of operating leverage and, beyond a certain point, cash flow from operations goes right to the bottom line.

An investor needs to consider where the cash came from, how it fits into the current circumstances of the company and what management really intends to do with it. Factors to be taken into consideration include the company's individual circumstances and a multitude of macro factors outside of the company's control. Cash requirements are difficult to determine because the underlying business dynamics are so difficult to predict. Pity the plight of a big-box retailer whose meticulous plans are destroyed when they discover they are being "Amazoned".

It is hard to know whether a large cash expenditure benefits a business or results in a non-productive giveaway. Is Facebook's (NASDAQ:FB) purchase of WhatsApp ($19b in cash and stock) a savvy strategic move or just a case of too much capital available to a young management team? Did the purchase of Motorola Mobility by Google (GOOG, GOOGL) ($12.5b) create real value, or will it just make Google seem overly aggressive to its current business partners? In the wake of the recent offer to purchase OpenTable (NASDAQ:OPEN) for $2.6b in cash, analysts have speculated whether Priceline (NASDAQ:PCLN) has overpaid. In a recent Seeking Alpha article, the author noted that, "It is hard to say whether Priceline overpaid for OpenTable or whether it even matters... PCLN has money burning a hole in its pockets."

Some Comparable Cash Positions:

Company

Market Cap ($b)

Cash on Hand ($b)

% of Cap

10-Yr. Return %

Google (NASDAQ:GOOG) (NASDAQ:GOOGL)

400.0

57.2

14.3

n/a

Facebook (FB)

170.1

12.6

7.4

n/a

Priceline (PCLN)

65.1

6.7

10.3

51.8

Apple (NASDAQ:AAPL)

567.0

41.4

7.3

49.1

Microsoft (NASDAQ:MSFT)

345.3

87.7

25.4

6.3

HP (NYSE:HPQ)

63.6

15.1

23.7

3.3

Wal-Mart (NYSE:WMT)

244.2

6.0

2.5

6.0

Coca-Cola (NYSE:KO)

185.6

19.4

10.5

7.9

Disney (NYSE:DIS)

150.4

4.1

2.7

14.1

Above Data from: Yahoo Finance 7/4/2014

Source: Fortune Magazine

6/16/2014

Click to enlarge

An alternative approach an investor can take to the "problem" of a company having too much cash is to avoid investing in the company, to begin with. It's not that we can always tell whether the cash will cause problems, but we do know that the cost of the cash will be baked into the purchase price of the stock, and that the investor will be buying all of the potential problems and missteps that go along with it. If a company is forced to actually raise cash for new ventures, it is more likely to be prudent. There is a reason why charity fund raisers (and scammers) prefer to approach wealthy people.

Another thing to keep in mind is that since a company's cash position is stated on the balance sheet, it is not a hidden asset, and other investors have built it into their calculations. Thus, it is hard to gain advantage over other investors by merely working the cash balance into your thinking. This is different from spotting other assets which may not be as obvious - such as undervalued real estate, valuable patents, new products in the pipeline or promising R&D. Understanding these other assets requires a level of awareness and judgment which can give you a leg up on the competition.

Most companies that have enough cash to attract attention are already large-cap. But these larger companies have a common problem - they are up against the law of large numbers. These companies are so big, they are unlikely to offer a bonanza in terms of growth rate or ROI. To hit a home run with a large-cap company, the investor needs to spot exceptional companies with exceptional circumstances.

One way to make evaluate a company's cash situation is to make an estimate of how much cash the company really needs or can profitably put to work. Do the analysis first, and then compare it to the actual cash on hand. Of course, this analysis is not simple. But you can begin by looking at the current ratio, cash generation and consumption in the last few quarters, and the cash situation for other companies in that industry or in similar stages of growth.

The bottom line is that when we buy stocks in companies that have large amount of cash, we pay full freight. In effect, part of our investment is in the business and the rest is in the carrying of the cash. This can be compared to parking some of your money in CDs or bonds. At times, it may be a good strategy, but it may just be a lazy approach to investing. The company is, in effect, holding (and often mismanaging) the cash for you. A better approach may be to invest in some other stock, hang on to the extra cash and look for additional investment opportunities.

Disclosure: The author is long GOOG, GOOGL, HPQ, FB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.