November 20, 2020
Looking for Cash: Finding Deep Value Investment Opportunities

If I sell you my wallet for $100, but it has $20 in it, how much are you really paying for it?

Of course, you intuitively understand that you can take the $20 cash out of this wallet so the actual cost of this wallet is that much lower because it contains cash. This principal applies to equity investments too.

In my previous posts, I wrote about how valuations are principally determined by the size, growth potential, scarcity and quality (i.e. reliability) of the earnings stream. Today, I want to discuss how we can refine this approach further by looking at the amount of cash within the business. In my opinion, this simple step has been instrumental in helping me unearth some stunning deep value investment opportunities over the years.

Cash De-risks the Business

Just like when you personally put money aside for a rainy day, companies that have extra cash at hand have more options in tough times. The future is uncertain so this is a very good reason you should look at the amount of cash within the business. With extra cash, a company could survive for longer if they go through lean times, or alternatively, they could use this cash to their competitive advantage and buy up their struggling competitors on the cheap in bad times, leaving them better positioned in any recovery. Cash gives you options and it’s rational that the valuation upside of cash-rich businesses can be higher.

Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.

What do I Mean by Cash?

Businesses need cash to generate earnings so usually most of the cash within the business is spoken for in terms of ongoing costs and investment plans. It’s important therefore to be clear how much cash a particular business needs just to operate and to grow. However, anything above that amount belongs to the owners, i.e. to us, the shareholders. By looking at the accounts and determining how much surplus cash there is, we can find companies with larger valuation upsides as, like the example of the wallet containing cash, we are effectively getting the benefits of this cash for free in the share price.

Metrics to Identify Cash

Net Cash

When I’m talking about cash, I mean cash that is “free and clear”: to find this figure, you take the total cash figure and minus short term debt, obligations and long term debt, and then you’ve got “net cash”. Net cash per share is just net cash divided by the number of shares in issue. Subtracting this net cash per share from the share price before calculating PE effectively gives you the price you’re paying ‘for the wallet’ in our example, as opposed to the cash + wallet price. If the net cash balance is high, this can lower your effective purchase price substantially.

Cash-Adjusted PE

Cash adjusted PE informational diagram

This is possibly my favourite metric in identifying deep value investment opportunities. A sizable net cash position can distort valuations. Cash-adjusted P/E shows more clearly how much you are paying for a company’s operating business.

To calculate the cash-adjusted PE, you only need four bits of financial data, all readily available in half or full year results, and from many investment websites:

  • Market Capitalisation
  • Net Cash figure
  • Number of shares in issue
  • EPS (ideally on a forecast basis)

In order to see why this measure is so useful, Let’s look at an example :

Let’s say you are looking at company A that is trading at $20/share with earnings of $1/share. The P/E ratio is 20. Also consider another company B that is trading at $20/share with earnings of $1/share. The P/E ratio is 20 as well. But:

  • Company A has $6 cash/share on the books but only needs $2/share to run its business.
  • Company B has $3 cash/share on its books and only needs $2/share to run its business.

So the normal PE doesn’t properly reflect the fact that Company A has tons more options to grow or pay dividends to its shareholders compared to company B. All things being equal, this extra cash per share means Company A is likely to be not only a far better investment but also a far safer one.

Cash adjusted PE comparison graphic Pynk Community

With that in mind, we can use this metric as a screen for bargain-priced stocks, looking beyond the traditional P/E to highlight some bona fide deep value opportunities like we’ve done below:

Deep Value opportunities infographic Pynk Community

But How Much Cash is Surplus is a Judgement Call by the Directors

It’s important to note that publicly listed company directors have a fiduciary duty to run the business in keeping with good corporate governance principles geared towards maximising shareholder returns - i.e. directors don’t really have a mandate to buy luxury corporate jets for personal use with company money and won’t survive long if they do! Directors are oftentimes also shareholders so their interests are aligned with that of us as shareholders.

However, the people running the business do have judgement calls to make regarding cash: the cash needs of the business are ever changing and usually very dependent on the economic backdrop. The directors use their management and sector expertise to decide how much cash to retain within the business. The cuts to many UK dividends in response to Covid is a good example of when company directors can choose to keep more cash in the business in uncertain times. Fast growing companies don’t often have surplus cash as their directors typically retain all the money they can lay their hands on to achieve their growth aims. However, after a decade-long uninterrupted economic expansion, some companies have entered this crisis with an enormous cash cushion. For example, if Apple didn’t sell another iPhone or Mac computer, it could operate for 492 days while continuing to make its products as it ended the past year with $247billion in cash, securities and account receivables. So unfortunately, this kind of analysis isn’t as simple as just looking at excess cash balances: this is a good starting point, but we still need a deeper understanding of the plans, risks and dynamics of the business.

Cash and Covid

The fast-spreading coronavirus has prompted even the biggest U.S. companies to cut their spending in order to bolster the cash within their balance sheets, proving once again that cash is king, especially in times of crisis.

companies cash burn Covid-19 infographic Pynk Community
“The investor mindset has shifted quickly to the balance sheet,” said Ron Graziano, an accounting analyst at Credit Suisse. “Sometimes factors that people don’t follow during a booming market suddenly become important. The ones going into it with the bigger cushion are better positioned to survive.”

Naturally, there are sector differences. Let’s take two extreme examples of the impact of Covid: on the retailing sector versus the technology sector. In contrast to the truly enormous cash cushion that Apple enjoys (enough to run their operations for more than a whole year), discount retailer Dollar General Corp. had $240million cash going into the crisis, enough to operate for about four days, in the unlikely event that it had to shut its doors and didn’t cut any costs. But realistically, there are usually cost cutting measures companies can and do make to address declining demand, and most do still generate some revenue in all but the most catastrophic downturns. In Dollar General’s case, its business model generates significant cash flow from its operations in almost all circumstances, can cut costs, curtail investment plans and/or tap lines of credit/access capital markets to survive the Covid storm.

Technology companies are often asset light and generally operate with more cash on hand than retailers, which often have part of their assets in perhaps difficult to liquidate unsold inventory. The median amount of cash and other readily available assets on an S&P 500 tech company’s books at year-end was enough to let it operate about 270 days in an extreme scenario without revenue or cost cutting, while the median was closer to 60 days for retailers, according to a Wall Street Journal analysis. Social-networking giant Facebook could keep its servers humming for more than 21 months without selling a single ad. Some of the companies that entered this crisis without big cash reserves used to send much of the cash they produced from operations to shareholders, as dividends. It is absolutely right that the directors should change their approach to cash levels as circumstances change.

“You’d have to be Rip Van Winkle not to be cutting costs as quickly and prudently as you could.” — Matt Furman, spokesman for Best Buy

The Implications When Looking at PE’s

Like most investors, I like the simplicity and intuitive feel of PE ratios, but it’s important to realise they are blunt instruments that can get us into trouble. A low PE ratio can be indicative of cheapness, but it can also be the result of low cash holdings. Conversely, a high PE ratio can point to overpriced stocks, but it can be distorted by high cash balances. I would suggest two simple rules to make PE ratios more useful:

  1. When comparing PE ratios across companies, don’t ignore cash holdings. As the diversity of companies within sectors increases, the old notion of picking the lowest PE stock as the winner is increasingly questionable, since you may simply be choosing the riskiest company with few options.
  2. Any corporate action that changes net cash as a percentage of company value will impact the PE ratio. Consider a company that has a large cash balance and is planning on using that cash to buy back stock. Even if nothing else changes, the PE ratio for the company would decrease after the buyback, as earnings are divided by fewer shares.

Cash is a Great Differentiator and Gives the Company Options

Obviously not every company is swimming in cash but it’s actually surprising how many actually are – through luck or judgement! However, there is no getting away from the need to undertake a detailed review of the business to determine the size of this excess cash figure. The beauty of this extra bonus money is that it can be easily used by the company to enhance shareholder returns: they could pay it back as special dividends or they could reinvest it in attractive higher growth areas. Looking at the cash helps you identify businesses that have this extra ‘turbo gear’ available to them in good times and this extra cushion protecting them in bad times.

Having cash is great especially in bad times, whether you are an individual or a company. I believe that most people would easily enhance their stock picking skills by looking at the cash a company has. The beauty of taking your analysis further than just looking at earnings measures is that, as fewer people are bothering to look at the cash, you have better odds of finding excellent deep value investment opportunities long before the market recognises them. I believe refining your investment process by looking at the cash in the business is one of the simplest ways of finding more great companies at compelling valuations.

Now It’s Your Turn!

As I said, one of my favourite metrics to find great companies to invest in is to look at those with low cash-adjusted PE’s. From a screen I highlighted above, you can see that UK listed miner Sylvania Platinum is currently trading on only 3x Cash-Adjusted PE!

Now it’s your turn: we in the Investment Committee are very much looking forward to enhancing our Investment process through the wisdom of this amazing crowd and invite you to tell us your

ideas of cash rich companies we should be looking at and why!

Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.

Written by
Pouneh Bligaard
View all my posts →
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