Cash Is King: 5 Reasons Why Cash-Rich Firms Belong In Your Portfolio

Every year, I stock up on old books at an annual fundraising sale held by a local college. Yes, I’m still one of the few who prefer turning pages by hand rather than swiping an electronic screen. One of my favorite finds was an old biography of Benjamin Franklin, which held a surprising secret… two worn $1 bills tucked neatly inside.

The book was already a bargain at just $4, but the unexpected cash discovery dropped the purchase price in half to just $2.

In much the same way, you’ll find that many of the nation’s greatest businesses are cheaper than they appear on the surface.

For example, look up a firm’s cash balance on Yahoo Finance. Then let’s pretend the company uses that money to pay off its outstanding debt. Does it still have a positive net cash position? Divide that by the shares outstanding, and you get net cash per share.

Now let’s say you were to buy this business today and immediately pocket that cash. The difference between what you paid and what it really cost you (after pocketing that cash) is what analysts refer to as enterprise value (EV).

5 Reasons To Look For Cash-Rich Firms

Of course, you and I probably won’t be buying entire companies outright and taking control of their bank accounts. But this is the approach used by private equity groups (as well as gurus such as Warren Buffett and Mario Gabelli) to find undervalued investment targets that turn out to be gold. And even the smallest stakeholder is still entitled to a pro-rata share of the wealth.

Factories, land, and equipment are great. But when push comes to shove, nothing beats cold, hard cash.

Valuation aside, I can think of at least five compelling arguments favor deep-pocketed businesses whose bank vaults are practically overflowing. Let’s take a look…

1) Less Exposure to Interest Rates

This one is a no-brainer. The Fed has tightened interest rates at the most aggressive pace in decades, and there could be another quarter-point hike soon. Cash-rich companies rely less on external financing, which becomes far more important when debt-servicing costs are rising.

Anybody with a revolving credit card balance understands the negative implications. Debt among S&P 500 companies currently stands at close to $6 trillion. A good chunk of that is variable, so borrowers are already paying more these days. The rest is tied to fixed rates and thus safe for now. But most companies like to roll over their debt before it comes due and extend the maturity. Going forward, that option will cost them a bit more.

For a business with $10 billion in floating debt, every quarter-point rate increase will drain $25 million from the bottom line each year.

2) Enhanced Portfolio Income

Companies sitting on large bundles of cash don’t bury it in coffee cans. Most park the money in safe, interest-bearing securities such as money market accounts, Treasuries, and municipal bonds. Over the past few years, with short-term rates anchored near zero, these instruments have earned a pittance.

Case in point, Prudential (NYSE: PRU).

Like any insurer, the company collects insurance premiums each month and later pays out claims to policyholders. During the lag time, investing this “float” is free to pocket any dividends and interest. Read back through the last few annual reports, and you’ll encounter terms such as “spread compression” and “low reinvestment yields.”

But those days are over. With about $500 billion in investments on the balance sheet, you can easily see the bottom-line impact of the Fed’s inflation-fighting measures. Every rate hike that siphons millions away from borrowers does the opposite for savers.

3) Less Concern over Liquidity and Financing

The cost of yesterday’s debt isn’t the only consideration. There is also the question of where and how companies will secure new capital for tomorrow. Since the 2008 financial crisis, Corporate America has enjoyed widespread access to cheap funds. But the easy money era is beginning to wind down.

This is particularly true for those with shakier credit. The spread of junk bond yields over comparable Treasury securities has widened considerably over the past year, meaning these issuers must now offer far more to coax investors into lending.

When the credit markets are stressed, access to funding can become cost-prohibitive — or shut down altogether. That’s when share prices really start diving south. This can be a particular concern for real estate trusts, oil and gas pipeline owners, and other groups that pay out most of their profit. Because they don’t retain earnings, these companies must frequently tap the capital markets to grow and expand.

Funding readily available in recent years will be harder to obtain as loose monetary policy turns more restrictive. Some pools will dry up entirely. On the flip side, companies sitting on billions of unused cash won’t have to beg for loans if the credit markets freeze up. They can access their own money anytime without relying on outside sources.

4) Greater Flexibility to Make Investments, Expansions, or Acquisitions

Fund manager Whitney Tilson refers to cash as “financial firepower” that can be brought to bear when it’s time to go hunting. Those with ammunition can go on the offensive, bagging big trophies for shareholders.

Flush with nearly $150 billion in cash, Warren Buffett’s Berkshire Hathaway had the means (and the patience) to pounce on numerous buying opportunities during the pandemic that will reward investors for years to come.

It’s not alone.

Microsoft is parting with $68 billion of its massive cash hoard to scoop up video game publisher Activision Blizzard. Apple has been bolstering its position in new fields ranging from facial recognition to artificial intelligence. Amazon is making bold moves in the telehealth market and branching out into robotics.

There’s no need to belabor this point. As they say, it takes money to make money. Companies that have saved their pennies will be better able to invest in growth projects or make accretive acquisitions that strengthen the bottom line. Undisciplined rivals with nothing to spare will be forced to stand pat.

5) Option to Return More Cash to Shareholders

This one is self-explanatory. Corporate borrowers must always repay their creditors first; common shareholders come last. Ordinarily, there is enough to go around. But when times get tough, highly leveraged companies can’t even guarantee current dividend levels — let alone hand out more.

By contrast, companies sitting on billions in surplus cash have a “rainy day” fund that can be tapped if necessary to preserve distributions during lean periods. They are also quick to approve dividend hikes (to say nothing of stock buybacks) when profits recover.

If nothing else, a large stockpile of excess cash tells us that a company has literally generated more profit than it could spend, a fairly reliable litmus test. And regardless of the economy’s path, they will be in a better position to respond.

Should the financial markets suffer some type of shock, there’s nothing more buoyant than stacks of money. And in prosperous times, these companies will be holding all the cards.

That makes cash a reassuring safety net and a springboard to opportunity.

Action to Take

Given its focus on dividend sustainability and growth, our portfolio over at High-Yield Investing naturally gravitates towards mature industry leaders that churn out buckets of cash flow.

I’m committed to renewing our focus on cash-rich firms in the months ahead. Given the current climate, you’d be wise to consider doing the same.

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