Cash Is King In These Troubling Times, Part II

by: Friedrich Research

<< Return to Part I

In September I wrote an article about the importance of using cash in one’s portfolio as a way to protect your nest egg. I use two basic concepts when investing my clients' money in order to protect them from large losses -- as there is nothing I hate more than losing money. My prime directive as an advisor is to attempt to minimize client losses during tough times and maximize their gains during good times. In this article I will attempt to explain my methodology in action.

My first rule is a top-down approach and is explained thus: Where there is great uncertainty, cash is king. And where there is little uncertainty, cash is your enemy.

What I attempt to do is go more to cash as negative catalysts show up and the worse things get, the more to cash I go. Currently I am in a large position in cash as negative catalysts are everywhere. Whether it is due to the incompetence of Washington D.C., politicians or the troubles in Europe, where countries as well as banks are on the verge of collapse, things are far from rosy and uncertainty is great.

Since as an investor you can never control macro events, it is very important to follow the news closely and track negative and positive events (catalysts). By keeping score you can then go more to cash as things get ugly and more to stocks when things improve. Currently I have my clients 75% in cash as I am expecting numerous downgrades by Moody’s (NYSE:MCO), Fitch and S&P (MHP) in the near future of most of the nations of Europe if not all of them. I am very bearish right now and have been for a while. I am beating the markets even though I am 75% cash because I don’t allow my clients to participate in the roller coaster rides that we have seen recently in the markets.

Earlier in the year I experimented with Deep Value investing, but the problem I encountered was that even though I bought some wonderful companies at extreme discounts, they just kept going lower and I learned a long time ago that once you find yourself in a hole, you need to stop digging. Value Investing has become more and more difficult as you can never tell where the knife will stop falling and finally hit bottom.

Companies like Nokia (NYSE:NOK) or Research in Motion (RIMM) have been in what Jim Cramer calls a “House of Pain,” so I have hung up my Value Shield and am concentrating on just buying companies with elite management at the helm, as the greatest problem one finds in trying to pick value plays is that their managements usually stink to high heaven or that you are buying the mistakes of past managements, where the stench from their mistakes has never gone away. Bank of America (NYSE:BAC) is a perfect example where past mistakes like Countrywide continue to be a stench that just won’t go away, no matter how hard management tries.

Sometimes management suddenly throws successful strategies out the window in one shot and shocks the world as with what has recently happened with Netflix (NASDAQ:NFLX), who recently threw the baby out with the bathwater. Value Investors are flocking into the stock but management has thrown a nuclear bomb into their business model and are all over the map announcing dismal future results a year out. What kind of planning is that?

I currently prefer to own companies like McDonalds (NYSE:MCD) and Yum Brands (NYSE:YUM), which have amazing management in place, incredible numbers and just keep knocking the ball out of the park. Value Investing is dead to me now as I see money masters like Bruce Berkowitz, of the Fairholme Fund (MUTF:FAIRX) wiping out past gains at incredible speeds due to their stubbornness. When what you’re doing is hurting your clients, you need to change direction and move on to something else, otherwise they will.

The second rule I live by is “capital appreciation through capital preservation.” This is how I invest in stocks, and is a bottom-up approach. I basically use two ratios to make my purchases: FROIC and CapFlow.

FROIC is basically Free Cash Flow Return on Invested Capital, or:

(Cash Flow - Capital Spending)/(Long Term Debt + Shareholder’s Equity)

This explains the Capital Appreciation part of my rule in that it allows me to identify companies that have achieved returns of at least a 15% on Main Street for every $1 of Total Capital invested. Basically in the real world of Main Street, far from Wall Street these firms are making a lot of money, so logically if you have a business whose cash register if overflowing continuously, there is a great probability of making some serious capital appreciation someday.

One company doing just that is Colgate Palmolive (NYSE:CL). Here are the FROIC numbers for Colgate from 1999-2010:

Click to enlarge

Colgate Palmolive is experiencing the same problems of every other company in the world, but it is still able to knock the ball out of the park, because it sells the basic necessities that everyone in the world needs on a daily basis and cannot go without. Everyone needs to brush their teeth daily, so no matter how bad things get, Colgate should do well. Add to this that the company has an elite management in place, and in 2010 returned $37 in free cash flow for every $100 of capital invested. You have yourself a cash machine in CL stock.

What I have done for my clients is invest in 25 or so FROIC powerhouses. The second ratio that I used to pick each of those 25 stocks is designed to practice capital preservation and is what I call “CapFlow.” CapFlow is basically Capital Spending/Cash Flow.

This ratio allows me to identify elite management teams that achieve very low costs in relation to their cash flow. Very simply they are usually the low cost producer in their industry because of their great attention to detail in their cost control management. They also able to use things like economies of Scale, where as their sales grow larger their costs per unit decrease. A master of CapFlow is Apple and here are their CapFlow numbers from 1980-2011(NYSE:E):

Click to enlarge

Apple, since 2004, has just been amazing example of excellence in cost controls, and is the main reason it has been able to put up the stock performance numbers it has. A CapFlow number below 50% is considered good, so Apple is knocking the ball out of the park. It also has an FROIC of 32%, which explains a lot. I am concerned about its growth rates in the future, and do not have my clients in Apple currently because if we go into a serious recession globally, smartphones are not basic necessities -- and thus consumers can go without.

It’s interesting that the price chart for Apple shows its stock started rocking in 2004 just as its CapFlow broke below 50% and continued going up as their CapFlow continued going down. Here is the price chart that shows you what I mean:

Click to enlarge

So there you have it, two simple rules that have worked very well for my clients as we are beating the NYSE Index (my benchmark) even though we are 75% in cash at the moment. Most of my holdings also pay a very nice dividend, which allows my portfolios to compete with the 10 year bond without taking on the ultra-bubble risk that I believe is equal to what the dot-com bubble in stocks that we went through in 2000.

Those investing in bonds today believe themselves to be safe, but eventually when interest rates start to rise they will pay dearly in principal for the errors of their ways. Bonds are at historic high prices with historic low yields and nosebleed territory is an understatement. It is better in my opinion to be in a large position in cash and have a portfolio of high FROIC/low CapFlow stocks that pay a decent dividend and are in the business of selling basic everyday necessities that everyone must use to survive.

Disclosure: I am long CL, YUM, MCD.

Disclaimer: Always remember that these are the results of our research based on the methodology that I have outlined above and in other articles previously published. This research is provided as an educational tool and should not be considered investment advice, but just the results of our research. There are many ways to analyze a stock and you should never blindly follow anyone’s work without doing your own due diligence or by seeking the help of an investment advisor, if you so need one. As Registered Investment Advisors, we see it as our responsibility to advise the following: We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong. Please note, investments involve risk and unless otherwise stated, are not guaranteed. Past performance cannot be used as an indicator to determine future results. Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.