Why You Shouldn't Invest in These Cash Kings

The old Wall St. saw says, "Cash is king," making cash-rich companies a great place to look for safe investments. That's especially the case today when risks abound, from Middle East unrest, Japanese natural disasters, to U.S. and European economic headwinds. Investors can't go wrong with balance sheets full of cash, right?

Umm, not exactly.

Not all cash-rich companies are created equally. Take General Electric (NYSE: GE), for example. With $127 billion on its balance sheet, GE is the Big Kahuna of cash. But if we stopped at the top, we'd miss the $467 billion of debt sitting between that cash and our pockets as shareholders. Translation: Bondholders have the first claim to that cash, not us.

Just because a company has lots of cash does not automatically make it a good defensive investment. In fact, I'll give you three reasons why you shouldn't invest in cash-rich companies, along with an opportunity to find out more about a cash-rich company that's ripe for the picking.

But first, here's what you need why you shouldn't buy cash-rich companies.

Cash is not always available
The GE example above shows why we cannot look at cash alone. We must measure it relative to debt and other obligations to determine how much of that cash is available to shareholders.

General Motors (NYSE: GM) offers another example. A quick scan of the balance sheet shows $26.6 billion in cash at $11.6 billion in debt. Coming out of its restructuring, things look great with 30% of its $50 billion market cap in net cash, right? Not so fast. With $60.1 billion in "contractual obligations and other long-terms liabilities," shareholders don't have a very strong claim to that cash. Investors interested in General Motors should therefore ask themselves how much cash it can generate tomorrow, not how much cash it has today.

Management can't be trusted
I'd argue management can't be trusted with bags of excess cash. Why not? Managers may have great track records of reinvesting capital back into their business to generate growth, but management's history with share repurchases and acquisitions is not as remarkable.

Between 2003 and 2007, share buybacks at S&P 500 companies quadrupled as the stock market approached its peak, before avoiding repurchases like the plague when share prices became attractive. To drive the point home, compare GE's purchases with those at Research In Motion (Nasdaq: RIMM), the maker of BlackBerry devices.

GE purchased $28.9 billion worth of shares from 2006 to 2008, but only $214 million (yes, with an "m") in 2009 and $1.8 billion in 2010. When you're worried about the viability of your business, capital becomes pretty important. Research In Motion bucked the trend by buying $595 million worth of shares during fiscal years from 2006 to 2008 and just over $3 billion since then. "Buy low, sell high" is the exception, not the rule, with share repurchases.

Cisco Systems (Nasdaq: CSCO) is well known in the business community for its acquisition integration process. That's good because Cisco's management loves to make deals. From 2006 to 2010, they invested $15.2 billion of capital buying other companies. Has it paid off? According to the table below, a definitive answer is unclear.

Source: Capital IQ, a division of Standard & Poor's. Dollars in millions.

Yes integration takes time and there was a giant recession along the way. But the numbers above show lots of cash flow out the door without much growth in cash flowing back in.

But can I do better?
Since managers don't always do the best job of repurchasing stock or making acquisitions, they should boost their dividends. That way, we can allocate it ourselves. But what do we do with the capital?

Dividends should only be reinvested in attractive opportunities. Consider the five-year records for Texas Instruments (NYSE: TXN) and Cummins (NYSE: CMI). Both are blue-chip companies whose dividends have been growing at impressive rates, averaging 35% and 26%, respectively, over the past five years. Yet Texas Instruments' stock price is only up 11% over the same time period, compared to a 382% gain for Cummins. The disparity is largely due to a substantial improvement in Cummins' product lineup that's been powering superior sales growth. While dividends are great, finding great places to put that capital isn't as easy as it may seem.

Let's turn that frown upside down
The best thing about knowing when not to invest in cash-rich companies is that if we flip things around, we have a recipe for finding attractive investment opportunities. Here are three things to look for when investing in cash-rich companies:

1. Plenty of cash net of obligations
2. Smart capital management
3. Growth opportunities which can lead to more cash

As I think through these criteria, one of my favorite companies comes to mind: optical networking equipment manufacturer Infinera (Nasdaq: INFN). The company has $275 million in cash and equivalents, which handily outpaces its $75 million obligations and zero debt. Management is investing heavily in its next generation product line, which should propel free cash flow forward over the next five years. What's more, the stock price looks cheap as investors bolted for the exits recently.

Infinera is the kind of cash-rich company investors should seek. It has plenty of cash today and should generate lots more over time. But it's not the one that I've prepared in my special report.

If you'd like to find out about the three strong trends and the money-making trade that I see, I'll be happy to send you a brand-new report I've written on the subject for free. Simply click here and enter your email address in the box to let me know where you'd like me to send it.

David Meier is an Associate Advisor for Million Dollar Portfolio and does not own any of the stocks mentioned. General Motors is a Motley Fool Inside Value recommendation. Infinera is a Motley Fool Rule Breakers recommendation. The Fool has created a bull call spread position on Cisco Systems. The Fool owns shares of Infinera, and Texas Instruments. Alpha Newsletter Account, LLC owns shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.