As an investor, I liked companies that are in a net cash position.
I viewed it as a sign of financial strength.
That view had changed slightly.
Today, I realised there is another context to companies with huge bank balances.
On the positive, such companies have cash to weather economic storms like COVID-19.
But, if companies have excess cash – to the point of hoarding – that is a symptom of laziness, or simply a lack of ideas to best utilise their cash-in-hand.
This defeats the original purpose for investing in stocks – which is to provide financial capital to them so that they can create value to customers, suppliers, distributors, and us as shareholders.
Value Creation Is Wealth Creation.
Think of it this way.
Would you invest in a unit trust fund that only holds onto cash and nothing else?
Logically speaking, no way.
If you like to hoard money, you can hoard them yourself.
You don’t need another vehicle to “save money”.
Worse still, you pay sales charges and annual management fees to help you save money. That is quite a waste as it is redundant.
But, you may wonder – “How is too much cash a negative for shareholders of a stock?”
Let’s examine.
How “Too Much Cash” Drags Return on Equity (ROE)
Assuming there is a stock known as A Co.
A Co generates a consistent earnings of $10 million a year.
It attains 100% cash conversion. Hence, its annual profits equals annual operating cash flows of $10 million.
A Co has $110 million in total assets – $10 million in cash and $100 million in other assets.
It owes $10 million in total liabilities. After deducting it, A Co has an equity of $100 million.
In essence, A Co produces $10 million in profits from its $100 million in equity.
Thus, its Return on Equity (ROE) is 10%.
A Co decides to keep 100% of its cash profits into its bank account that yields 0%.
It runs its business as usual and earns $10 million a year.
It maintains the value of its other assets and the amount of liabilities it owes at constant.
Thus, A Co would begin to pile up cash from $10 million in Year 1 to $20 million, $30 million, and eventually $40 million in Year 4.
Because of this, A Co’s equity grew from $100 million in Year 1 to $130 million in Year 4.
But without growing earnings, its ROE gradually falls from 10.0% in Year 1 to 7.7% in Year 4.
Let’s say A Co has 10 million shares outstanding and has a constant PE Ratio of 10.
Thus, its stock price would remain constant at $10 a share.
Your capital would not go anywhere.
If A Co Reinvest Cash at ROE = 10%
Here is another scenario.
If A Co retains $10 million in cash (as emergency fund) and chooses to reinvest annual earnings into assets that generate ROE of 10% per annum, its earnings would start to grow over time.
Assuming that its PE remains constant at 10.
Its stock price would appreciate from $10 in Year 1 to $13 in Year 4.
You are compounding your wealth.
Key Takeaways for Investors
Hence, there is a difference between a stock that hoards cash and a stock that compounds.
The first may pile up cash in the name of “financial prudence” but lacks ideas of utilizing it.
The second is preferred as the stock has the ability to create value and compound wealth.
So, the key takeaway is not just to focus on what a stock has in its balance sheet.
Rather, we should focus on a stock’s long-term capital allocation strategy and how efficient it is in reinvesting its profits over the long-term. Such a track record is measured based on ROE for a long period of time.
