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.

Cash Metric

FY2007

FY2008

FY2009

FY2010

FY2011

Cash Acquisitions

($3,684)

($398)

($426)

($5,279)

($3,065)

Cash from Operations

$10,104

$12,089

$9,897

$10,173

$10,475

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.


Read/Post Comments (6) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 29, 2011, at 10:07 PM, BradReeseCom wrote:

    Hi David,

    I think the "quality" of Cisco's cash from operations is either faltering or NOT sustainable.

    I mean, at some point tax dodging, overseas outsourcing and outragious stock option compensation for management begins to take a "toll" on a company like Cisco.

    Well, at least that's my opinion!

    Sincerely,

    Brad Reese

  • Report this Comment On April 30, 2011, at 11:01 PM, porchguy wrote:

    That might be your theory, but it doesn't always work the way you said it does.

    I have made 27.72% off GE in less than a year. I think I'll stay with my way of figuring out value of a companies worth.

    GE has and will for the foreseeable future have some great potential with all there diversification..

    Just my opinion

    HollywoodBob

  • Report this Comment On May 01, 2011, at 8:14 AM, midnightmoney wrote:

    GE: here today, gone tomorrow!

  • Report this Comment On May 02, 2011, at 2:58 AM, Matt84 wrote:

    GE has had a measley 2 percent sales growth the last five years and a negative 6% eps growth the last five years. If I had to do it over, I would not buy GE.

  • Report this Comment On May 04, 2011, at 3:03 PM, mikecart1 wrote:

    In one article, we should invest in cash kings, in another we shouldn't. When new investors come read these articles they wind up doing nothing lol!

  • Report this Comment On May 08, 2011, at 8:10 PM, 712Mike wrote:

    yes I agree...this must have been a quick artical written on Friday afternoon....you can't have it both ways....I sincerely hope GE does well....I'd like to see CSCO come clean with their intentions and bring jobs home.

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