Is Your Stock A Sinkhole Or A Geyser? Part 2

by: Hedge Fund Trading Academy

We prefer businesses that drown [us] in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.

- Charlie Munger, Berkshire Hathaway 2008 Annual Meeting Notes

In Is Your Stock a Sinkhole or a Geyser? Part 1, I categorized companies like Martha Stewart Living Omnimedia (NYSE:MSO), Rite Aid (NYSE:RAD), Goodyear Tire (NYSE:GT), Great Wolf Resorts (NASDAQ:WOLF), and Pacific Ethanol (NASDAQ:PEIX) as "sinkhole stocks." These are businesses that have generated negative free cash flow for the last 7-10 years. As a result, they have been forced to issue debt and stock in order to keep their doors open. In order to pay a dividend, a sinkhole stock must rob Peter to pay Paul-- and sometimes even rob Peter to pay Peter.

Today, I want to discuss the opposite type of business: "geyser stocks." These are businesses that are absolutely gushing cash, like IBM (NYSE:IBM), Hansen Natural (HANS), Thor Industries (NYSE:THO), WD-40 (NASDAQ:WDFC), and Rocky Mountain Chocolate Factory (NASDAQ:RMCF). All five of these companies have generated positive free cash flow for the last 10 years, in each and every year: (Click to enlarge)

These companies are in different industries, and in both high and low margin businesses. But they all possess an almost magical ability. Each is able to take a dollar of revenue from selling its products or services, use it to pay its suppliers/employees/rent/utilities/insurance/etc. and to maintain its equipment, and still have money left over to write its owners a check.

Unlike sinkhole stocks, these geyser stocks are free to use their cash gushers to expand the business, pay off debt, buy back stock, or pay shareholders a dividend.

Geyser stocks are often self-funded by their own free cash flow: McDonalds (NYSE:MCD) is famous for having never issued stock (on net) since its IPO (though it has taken advantage of low interest rates to conservatively lever up the company over the last few years). In-N-Out Burger and Trader Joe's presumably spit out so much cash that they have been able to remain private and fund their growth internally.

Take a look at the companies in your own portfolio. Do you own all geysers, or have a couple of sinkholes slipped in? Few people are willing to tolerate negative cash flow on a rental property, yet every day investors line up to purchase shares of sinkhole stocks.

No price is low enough for a sinkhole stock. Theoretically, a sinkhole stock should trade at a negative share price to compensate you for taking your perfectly good cash and incinerating it.

No price is low enough for a fox that eats golden eggs. Which begs the question, how much should you pay for a goose that lays golden eggs, like a geyser stock? The answer will have to wait for my next article.

Disclosure: I am long RMCF, MCD.

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