Investing is much like economics - scientific yet subject to constant change and revision. The battle between growth and value carries on with shifting popularity depending on whichever theory proved most justified by recent market behavior. Sadly for the value investing community, their theories of balance sheet and "margin of safety" seem to carry less weight of late. The market is systematically under-pricing corporate balance sheets at the moment in favor of yield and growth. In some of the most absurd examples, we see REITs with large debt loads paying out almost all of their cash to yield less than 4% while companies with net cash and earnings yields of 8% trade a far lower multiples. Benjamin Graham would be turning in his grave!
This article will explore a few of the reasons for this paradigm shift and why it is unlikely to persist for long.
Cash held on balance sheets is generally maligned by the investing community as it reflects:bas
1) lack of growth opportunities
2) poor management discipline in returning capital to shareholders
3) destruction of shareholder value as cash earns well under the corporate cost of capital
So rather than perceive cash as an asset, investors either completely discard it in their valuation model or potentially treat it as a liability for the reasons stated above. While all three concerns are valid, only a fool would prefer an identical company without cash to one with cash for the same price. Cash is an asset and can be used for share buy-backs, dividends, acquisitions, and a capital buffer to ensure on-going access to capital markets at reasonable rates. Even if one were to assume cash is trapped overseas, you may haircut it by the corporate tax rate and still use it as needed (or buy foreign assets that generate earnings).
So this brings me to the market obsession with growth. Any cash rich company can create growth through acquisitions. Take two companies in the same industry. Company A has 50% debt/market cap and company B has 50% cash/market cap. Both trade at 10x earnings. If one were to assume that company B could buy another business at 10x earnings (or buyback shares), then levering up can dramatically increase earnings (or EPS). If company B were to borrow 50% of it's market capital and spend its entire cash, then it would effectively double the business. So the combination of cash and debt would create 100% earnings growth overnight. If the share price were to remain the same, company B would now trade at 5x earnings and company A would trade at 10x earnings. Both would have identical capital structures but drastically different valuations. For the sake of simplicity, I ignored interest on cash and debt, though rates and credit spreads are sufficiently low that it would make little difference to the results.
So why does the market fail to price this potential value through capital re-structuring? Several reasons come to mind. First, companies generally overpay for acquisitions which means the acquisition is purchased at a higher multiple than the existing business. This would appear to dilute the shareholder and destroy value. But this is only true if the market values the cash on par with the business. If the market discards the value of cash, then acquisitions- even at inflated prices- would result in a higher valuation (since the market values earnings and growth over cash). The second reason for ignoring this potential value has to do with motivation. A company's management may have a different risk profile and utility function than the shareholder. For example, management may see value in creating a buffer to protect themselves and their reputation in times of crisis (i.e., risk aversion). They may also wish to retain "dry powder" for acquisitions, or simply wish to run a larger company. None of these reasons makes sense for the shareholder, though all of them make sense for management. This raises a broader question of how does one ensure management pursues the best interest of the shareholder over their own?
In the United States, shareholder activism and M&A activity help align the interests of managers and shareholders. Small companies with large cash balances and a history of stable earnings growth do not trade at 10x earnings in today's market for one simple reason: they get bought out. Private equity could snap up our hypothetical company B and arbitrage the capital structure. They could buy the company, issue loads of debt to pay themselves back, and pass most (if not all) of the downside risk to the bondholders. The private equity firm would have effectively arbitraged away the market failure. In our example above, if the PE firm were to buy the company at 10x earnings and covert the cash to debt, they would have received a free company! The combination of 50% cash and 50% debt would have returned to them the full purchase price. If this company were to pay a 20% premium, they would effectively have purchased a company for 2x earnings! Again, this ignores the cost of debt, but given the credit markets hunger for yield, issuing 10y bonds at say 4% (UST + 200 bps) will hardly change the math.
So where do we find our neglected cash cows? Cisco Systems (NASDAQ:CSCO) is a prime example. CSCO holds a net USD 30 billion in cash (46.3 billion in cash and 16.3 billion in debt), which represents 24% of the market capitalization even after the recent 15% surge in price. With levered free cash flow of 8.5 billion per annum and an A+ credit rating, CSCO has ample scope to issue more long-term debt at very low rates (more than 10% below their return on capital). With the exception of fiscal year 2009, CSCO has grown revenue and earnings every year for the past decade. On a per share basis, revenue has grown 11% per annum and Earnings at 15% per annum over the past 10 years. While the pace of growth has slowed modestly over the past five years, it still averaged 10.5% for both revenue and earnings. Unlike many companies trading at higher multiples today, CSCO continued to generate very good profit at the height of the 2008-2009 recession. Even with the drag of holding low yielding cash, CSCO still generates a healthy 20% return on shareholder equity and 15% return on assets.
So how is it possible for a cash cow like CSCO to trade at 13x trailing earnings and 11x forward earnings without being bought out? The simple answer is size. With a market cap of 125 billion, the company is far too large for any buy-out. Does this mean the company does not warrant a higher valuation? Absolutely not since the upside potential is still there for management to exercise. Fortunately, CSCO management now sees the light and has committed to return 50% of operating free cash flow to the shareholder in the form of dividends and share buy-backs. While still early days, expect this resolution to eventually impact the price. Somewhat earlier than CSCO, Microsoft pursued a similar strategy to return cash to share holders. As a result, the company was re-rated and now trades at 17.7x earnings. Expect the same from CSCO.
Disclosure: I am long CSCO.
Additional disclosure: I have no positions in MSFT and do not plan to initiate in the next 72 hours