Cash Is King

by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
October 2, 2007

Updated from the Fall 2005 issue of On Investing, a magazine for Schwab clients.

Investors are often told to look for companies that have a strong balance sheet, using measures such as long-term debt/stockholder's equity. While such a ratio may help quantify fundamental risk, by itself, it has little use as a stock selection tool. Schwab research has found that historically, stocks with little or no long-term debt have not outperformed market averages. Not surprisingly, the stock market is generally too efficient to reward metrics in such widespread use.

But one should not conclude that balance sheet strength is irrelevant for stock selection. We propose the ratio of Cash and Marketable Securities to Market Capitalization as a balance sheet indicator that is also simple and intuitive, but apparently not fully appreciated by the market. Among the 3,200 largest U.S. companies by market capitalization, simulated portfolios containing the 5% of stocks with the most cash have historically outperformed the average stock by over 9.2% on an annualized buy-and-hold basis over the period 1986–2006 while the 5% of stocks with the least cash have historically underperformed the average stock by 4.5%. While past returns don't guarantee future results, the potential power of this simple indicator is intriguing.

Why might investors be attracted to the stocks of cash-rich firms? Several possible explanations come to mind. First, lots of cash affords a firm financial flexibility. Cash can be used to cover operating losses during times of business stress. Cash also provides the means to reinvest back into the business as opportunities occur without the costs and delays associated with raising new capital from outside investors.

Second, cash-laden firms often return funds back to shareholders in the desirable form of dividends and share buybacks. Shareholders also tend to react positively when cash is used to pay off long-term debt.

Third, lots of uncommitted cash on the balance sheet helps make a stock a potential buyout candidate. With all of these desirable attributes, it remains a mystery why investors haven't bid up the shares of cash-rich firms enough to wipe out their historical return advantage!

One note of caution in researching the investment merits of firms with lots of cash on their balance sheets: It's critical to understand where the cash came from. The Statement of Cash Flows (found in a firm's annual 10-K report) is a great tool for this purpose because it reveals the sources of recent changes in a firm's cash balance. For example, a firm generating positive cash flows from operations is preferable as this is a sign of a healthy business. On the other hand, a firm whose high cash balance stems from recent financing efforts such share offerings or debt issues, or from investing activities such as the sale of business unit is much less interesting as these sources of cash flow tend to be one-time shots.

To help you get started looking for cash-rich firms, here are several stocks which, as of September 18, 2007, we consider worthy of further research.

Company and ticker symbol	Stock price	Market cap ($millions)	Schwab Equity Rating	Cash / market cap	Share buybacks in the past year (Yes/No)	Dividend yield
Frontier Oil Corp. (FTO)	$44.43	$4,780	A	0.11	Yes	0.5%
Ashland Inc. (ASH)	$59.98	$3,768	A	0.26	Yes	1.8%
Continental Airlines, Inc. (CAL)	$32.68	$3,192	A	1.05	No	N/A
Cooper Tire & Rubber Co. (CTB)	$22.93	$1,432	A	0.23	No	1.8%
McKesson Corp. (MCK)	$54.19	$16,040	A	0.20	Yes	0.4%
Novell Inc. (NOVL)	$7.36	$2,574	A	0.71	No	N/A
AES Corp. (AES)	$18.15	$12,130	A	0.28	No	N/A

^{Schwab Equity Ratings are as of September 18, 2007. Share price and other data are as of September 14, 2007.}

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

The Schwab Equity Ratings® are not personal recommendations for any particular investor. They do not take into account the financial, investment or other objectives and may not be suitable for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Additionally, investors should consider any recent market or company news. Stocks can be volatile and entail risk. Individual stocks may not be suitable for any particular individual investor. While A- and B-rated stocks as a group have outperformed D- and F-rated stocks as a group, individual stocks have performed differently than the group as a whole. See Schwab.com for further information.

Past performance is no guarantee of future results.

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