Buying stocks of companies that are sitting on a cash pile is a common bear-market strategy. The assurance stems from the protection that cash offers during market upheaval. The need for at least a steady income increases the demand for cash-rich stocks in bad times. But what is it that stops you from taking on this strategy and investing in cash-rich stocks in any other market phase, in particular a bull market like now?
The common perception is that huge cash holding in a bull market means failure to grab opportunities. This notion is not wrong at all; companies of this nature will end up burning through their cash stash to fund operations.
But those hoarding huge cash on their balance sheets by balancing their deposit and withdrawal rates offer a higher margin of safety compared to those with low cash balances. So I don’t see any reason to not prioritize true cash-rich stocks in any market situation. After all, who doesn’t require protection?
What I mean by protection…
While investing in a stock, not only are you paying for the ongoing business of the company, but also its cash power. While the business can flop, the cash will not. Even if the company loses earnings power and chooses to liquidate, it should not affect your investment much. And if you get the opportunity to pay less than the market value of the company’s business plus the cash it holds, the liquidation could bring rewards.
But is liquidation that easy for these companies? Of course, because the potential acquirer needs to actually pay the difference between the current market capitalization and hoarded cash (considering a no-debt situation). So, higher the cash position, lesser the expense for the acquirer. This whets the appetite of potential acquirers.
Cash-rich companies not only guarantee protection, these also have high chances of returning to shareholders from their deep cash balances through dividend and repurchase. Past records affirm that dividends and share buybacks contribute more to the growth of a majority of portfolios than price appreciation.
On the other hand, these companies have the option to pay down debt and grow organically and inorganically that can translate into share price momentum. It all depends on how the companies plan to efficiently deploy their cash balances.
But the possibility of dual return — from dividend/share repurchases and price appreciation — is always there.
The Tactic to Find Real Cash-Rich Bargains
It’s not easy to find real cash-rich stocks unless you know the trick. Here I have discussed the method and created a screen (using Research Wizard) that you can run in any market, good or bad, to find potential winners.
How to Look at Cash?
Of course, it is a relative measure, so a high number doesn’t necessarily indicate affluence. How much cash a company holds relative to its market capitalization is the actual way to look at it — the higher percentage the better.
So cash as percentage of market cap is the key to finding cash-rich bargains. I searched companies with cash and marketable securities of at least 80% of their market capitalization. If you buy stocks of these companies, less than 20% of your investment will be directed to their ongoing business — the risky part. So at least 80% of your invested capital will be secure if the company is debt-free. Even if the company has some debt, your risk exposure is marginal.
Screening Criterion: (Cash and Marketable Securities/Market Capitalization) >= 0.80
Look for True Cash Generators
A company hoarding ample cash does not do any good for your investment if it is burning through it only to fund operations. If the company doesn’t have the potential to earn sufficiently to refill its initial cash, the reserves could be ultimately exhausted.
To guard against that, first I required positive cash flow from operations. Then I looked for companies that are expected to be profitable in the current fiscal year. Here are the screening criteria that I added:
Operating Cash Flow > 0
Current Fiscal Year Consensus Estimate > 0
Eliminate Typical Cash Owners
Some businesses demand huge cash holding by their very nature. I eliminated companies from Finance and Medical sectors as these tend to have a lot of cash on hand for the nature of their businesses. Cash is the basic operating asset for finance companies while medical companies keep cash in hand to fund their R&D.
Screening Criteria: Sector <> Finance; Sector <> Medical
Ensure Favorable Zacks Rank
Good market or bad, stocks with a favorable Zacks Rank http://www.zacks.com/education/stock-education generally outperform. Zacks Rank #1 (Strong Buy) and #2 (Buy) stocks, which have a proven history of success, have actually witnessed positive earnings estimate revisions over the past few weeks.
(See the performance of Zacks’ portfolios and strategies here: About Zacks Performance).
Screening Criterion: Zacks Rank <= 2
How Successful the Strategy Is
For examining how profitable this screen would have been in the past, I backtested it with a 24-week holding period over the last 10 years. I found that the group of stocks matching these parameters significantly outperformed the S&P 500, as you can see here: