Giving more credit to stocks that have cash
This Canadian analyst returns to business school to show how investors can miss out on cash-rich companies, like two retail stocks.
Let’s go to business school.
We don’t have to take the whole curriculum. We’re just going to look in on one debate that illustrates a very important point for investors.
Namely, that companies that are rich with cash often get overlooked simply because they don’t post the glamorous figures many analysts like.
Yet what could be more important than cash in the wake of a three-year credit crisis fuelled by enormous piles of debt?
Not much, says Mr. John Sartz. This seasoned investment executive writes regularly for Investor's Digest of Canada. He frequently cites personal experience as a way of underlining important points.
In his latest article, he turns to a friend’s daughter who is in business school. In an exercise designed to compare the investment merits of two different companies, he discovers a very strong argument for cash.
He follows up by discussing two Canadian retail stocks that he believes should be getting much more credit for their wise management of cash.
What’s more, the exercise gives us some insight on just how we should view the arguments analysts make for the stocks they support.
Find the flaw
The business school project pitted company A versus company B.
The team supporting company A had two strong points to make. The company’s return on equity (ROE) was superior to company B’s. Yet it was available at a lower price/earnings (PE) ratio than company B.
In short, it looked much more profitable, and cheaper at the price.
“This, the team argued, implied a market inefficiency which ought to be exploited through purchases of shares in company A.”
Mr. Sartz’s friend’s daughter was on the B team, which had to find the flaw in this compelling argument. The flaw was debt.
A matter of judgment
In order to use return on equity as a measure of profitability, says Mr. Sartz, one must consider a company’s balance sheet.
As long as the return on assets exceeds the rate of interest paid on borrowed money, financial leverage can be used to enhance return on equity, he explains.
It’s all a matter of judgment. “Different levels of debt are appropriate depending on the industry,” says this analyst. With their revenue streams, pipelines can easily handle four dollars of debt for every dollar of equity. The same level for a manufacturing company “will prove suicidal.”
When analysts and investors seek out a high return on equity and low price/earnings ratio, they often ignore the amount of debt involved.
And yet while too much debt can be dangerous to a company’s health, a pristine balance sheet can cause a company to be overlooked.
Excess cash brings in small yields, which reduce the return on equity. That in turn pushes up the price/earnings ratio.
Mr. Sartz uses two examples to demonstrate how misleading these figures can be. Both are frugal retail stocks.
Could look flashier
If you look at its return on equity, Leon’s Furniture (TSX-LNF) is ahead of the broad market. Based on the past 12 months’ earnings, the ROE is 16 per cent. That’s against a TSX average of 10.4 per cent.
What’s more, Leon’s price/earnings ratio of 14.7 is also cheaper than the TSX, sitting around 18. Looks pretty good so far.
But there’s more, says Mr. Sartz. Not only does Leon’s have no debt, it has cash and marketable securities worth some $2.15 a share.
Buy this company’s stock, he adds, and you’re getting the actual value of the shares ($11.95 today) plus more than $2 in cash. This could crystallize into an extra dividend.
And if we go back to the battle between teams A and B, we see that Leon’s could look even flashier if not for its cash. Exclude the cash and the PE ratio is even more attractive at 12.
Plus the cash, which yields no more than two per cent, is a drag on profitability. Without it, the stock’s ROE is an imposing 25 per cent.
In short, Leon’s would look better to many investors if it weren‘t for all that cash. But would investors really feel better if it was cash-poor? Leon’s is yielding 2.4 per cent on its $0.28 dividend, by the way.
Gold-plated balance sheet
Another tight-fisted retailer, Reitmans (Canada) (TSX-RET.A), has even more cash on hand — $4.75 a share in cash and investments.
On the face of it, Reitmans has a return on equity of 14.7 per cent and a price/earnings ratio of 15.2. But take away the cash, says Mr. Sartz, and the ROE jumps to 36 per cent, while the PE is as low as Leon’s at 12.
In the 30 years he has followed these companies, they have been hoarders of cash, reports the analyst. In at least one respect, he has changed his opinion.
“Earlier in my career, I thought of Jeremy Reitman, the CEO of Reitmans, as being overly conservative. Although I still feel that he has an excessively gold-plated balance sheet, I have certainly modified my view about his skills as a merchandiser.”
The company’s two major competitors, Dylex and Grafton Group, didn’t make it out of the twentieth century, he points out. Reitmans has thrived, and its cash position allows it to make important acquisitions.
It trades at $19.54 and yields 4.1 per cent on the $0.80 dividend.
Mr. Sartz never tells his Investor's Digest of Canada readers who won the contest between Team A and Team B. But he obviously sides with Team B when it comes to the cash side of the equation.
When stock pickers rely too much on certain ratios, he says, they could be walking right past some buried treasure.
|
E-mail this article
Printer-Friendly
