Every investor’s goal is to find undervalued investment and then sell it when it reaches fair value. To find the fair value of a common stock, we need to predict the profits generated by the stock over a period of time. This prediction may not be accurate. After all, nobody can know the future with 100% certainty. When things unexpectedly turn ugly, investors need to guard themselves against capital losses. The way to reduce this risk is by investing in companies with positive net cash.
Net Cash is the difference between cash & short-term investments with the amount of long term debt. We can find this three items on the balance sheet of every company. A lot of times, one can include long term investment as cash. Long term investment can include instruments such as 18 month Certificate of Deposit or treasury bond maturing one year or more. To be on the safe side, let us consider just cash and short-term investments.
You might wonder why we do not subtract short-term liabilities such as accounts payable. Good question. The reason is that accounts payable is normally used to buy inventories. Some of the revenue is also tied up in accounts receivable. In normal business operation, these two things can be used to pay for short-term liabilities. There are of course exceptions such as banks where they use short-term liabilities ( customers’ deposit) to give loans (long-term investments) to businesses or individuals.
Once we understand why we define net cash the way they are, we can then appreciate the function of it. Net Cash defines the financial structure of a company. We can tell companies with strong financial structure by looking at its net cash position. Generally, investing in companies with positive net cash is less risky.
As the word implies, positive net cash means that the company has more cash in hand than long term debt. In other words, the company is less leveraged and less burdened with debt. It can pay its long term debt right away if it wants to. This is the right way to leverage a business.
All of our sample portfolio stock picks have a positive net cash on their balance sheet. The reason is that when our prediction fails, the company is less likely to go bankrupt. When a company has plenty of cash, it can afford to incur losses until its business turn around.
Another reason is that companies with positive net cash can afford to buy assets on the cheap during economic downturn. When the economy is in a bad shape and losses are mounting, weaker companies tend to raise cash by selling off its valuable assets. Companies with positive net cash will be there to buy.
Finally, companies with positive net cash can afford to buy back shares or give dividends even when businesses are bad. It is no surprise. They have more financial muscles than others to be generous. This will benefit common shareholders like us.
There are some investors that feel that companies with positive net cash are not efficient. They reason that companies should take advantage of the power of leverage so that it can maximize shareholders’ return. Well, their view is not wrong. Buying companies with positive net cash might not give you a 10 fold return in one year. But, you won’t lose all your capital in one year either. It is all up to you. Do you want to maximize your investment return with incredible risk? Or do you want to get a decent return while minimizing your risk? I prefer the latter.