When prospecting listed companies to buy, good companies might not always have a lot of cash. You cannot prioritize cash being higher in the decision to buy or not to buy.
One of the gracious opinion provided by a reader to my brief prospecting of Transit Mixed Concrete is that the cash to debt ratio was not ideal. My inference is that high cash to debt is appealing.
In some cases it is and personally, when I see a high net cash company relative to market capitalization (stock price x number of outstanding shares), it also intrigue me to take a second look.
However I will perhaps show you by the end of this while this is a valued metric to consider, it usually isn’t something we should place high on the list of evaluation.
Here are some of my thoughts.
High Cash reduces the Return of Equity
As a shareholder in the company, you want an efficient functioning machine. By efficient, you would want a management in a better position in deploying the capital they have on hand.
If the business keeps a lot of cash around, those go underemployed, that means capital are not deployed efficiently.
In some businesses, you cannot recycle the capital into the business because the business do not need to use so much cash. Some companies such as VICOM is one (here on the dividend stock tracker).
In the case of IFAST and ARA, they are high return on equity or even return on invested capital business (ROIC), and they do currently have ways to deploy their capital in new markets and seed capital for new private funds in the case of ARA, but they will hit a point where there may not be an addressable market any more.
Growing companies eventually will mature, and in that case, is it wise to keep a huge amount of capital?
The wise decisions is perhaps to buy back shares to improve earnings per share (shrinking the equity base) or to pay back as dividends.
It is here you see whether the management is making a good decision.
For the case of Transit Mixed, the imaginary scope is to go to another country. However, if the management is conservative and deemed hard to get a higher ROIC versus their cost of capital then they would remain in Singapore, which they have already built up the required capacity.
What do we do with the cash? Pay off lease obligations or debt and pay out as dividends.
Nature of debt financing and amortization of debt
While there are businesses with high debts, the more important note is whether the debt is rolling over amortizing.
In the case of Singapore Shipping Corp, after their massive purchase on leverage, their net debt to asset went up to 51% and net debt to EBITDA 4.46 times. That does look dangerous.
However, different business takes different risks and different ways how they use debt.
In a low interest environment, China Merchant Pacific and Singapore Shipping Corp are the dividend stocks that pays down the principals while most of the REITs roll over their debt. The former may eventually end up with less leveraged risk then the latter as Singapore Shipping Corp in the past have shown to be net cash in face of massive shipping exuberance.
Transit Mixed Concrete have shown that they are managing the lease obligations, paying down where possible.
Even some of the net cash businesses such as Straco started off with high debt and with their cash flow over the years it ends up net cash.
To know the nature of how the management handles debt, it requires speaking to them about this and also observing the past annual reports to get a sensing in this area.
Cash Flow is a more meaningful metric to watch for
Cash Flow is different from Cash. It is fluid and the lifeblood of any business. And in annual reports there are many forms. If you are unable to differentiate, perhaps my explanation of Net Profit, EBITDA, Operating Cash Flow and Free Cash Flow can enlighten.
My thinking has shifted a fair bit after being influence by John Malone that watching the debt to cash flow matters more than watching the debt to asset.
If you look at Transit Mixed EBITDA or Net operating cash flow looks good to cover the lease obligations.
In this way, the business do not keep excessive cash, yet you know the business produce enough cash flow to cover the debt.
Huge Cash Hold only matters if Management have motivations to realize
While we can use net net metrics to measure a business like Asia Enterprise Holdings, where you are almost paying the share price for their entire cash holdings only, without ‘motivation’, it will likely remain undervalued.
As a net net Benjamin Graham investor, you have something that is undervalued, but it will take some time for it to realize, usually it is:
- a change of heart to pay out a special dividend
- being taken private
- bought over
To me it is safe, and attractive, only if you look at it from the net net angle
After you hear my point of view, have you have a consideration of the cash holdings of the company you invest in? Is it high in your listed company evaluation model?
I think this is something to think about. It is also something to straighten out if this is a fundamental investing area you are not that familiar with.
Cash holding might look safe, but in some businesses, it will eventually bleed out when the nature of the business consumes the cash as part of working capital when the business climate isn’t that favorable in the case of Nam Lee and Asia Enterprise Holdings.
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