Tag Archives: Portfolio

Excess Cash

What exactly is excess cash? To me it means cash that is on the balance sheet that is not needed in day-to-day operation of the business. Some companies have no excess cash and some have enormous amounts of excess cash. This post may seem like review to some, but a younger version of myself would have benefited from this insight.

What can affect the amount of cash needed for day-to-day operations:

  • How cyclical/seasonal is the company
  • Length in sales cycle
  • Whether the company does large amounts of contract work, making revenue and expenses lumpy
  • Customer concentration
  • Working capital requirements
  • Capital expenditure requirements
  • Access to funds (reasonable borrowing rate)
  • Dividend rate

Lets look at some examples:

Velan (VLN on TSX) manufactures and markets industrial valves. Revenue growth over the last 10 years has been slightly better than inflation. The company has a very long sales cycle, as evidenced from the CCC being over 200 days. Currently stated net cash is just over $5 per share. This seems extremely attractive to anyone buying the shares now (around $13). You can say that I am buying the business for $8 ($13 minus $5). Average EPS for the last 5 years is $1. So I am paying 8 times earnings, which seems very cheap. This of course is oversimplistic, but it proves my point. But wait a minute, over the last 10 years there has been at least $25 million in cash on the balance sheet (or about $1 per share). This may mean that there will always have to be $25 million cash on hand. Now your valuation goes to 9 times earnings, ($13/share minus $4/share in excess cash divided by $1 in EPS). Also we must consider that VLN has had revenues fall sharply during the recession and are not likely to return for quite some time. Working capital will need to be adjusted as well. Something that is very important is the voting structure of the company. The Velan family has voting power, which leaves almost no chance of activist involvement. The family can take the company private, but I am reluctant to speculate on that. I think there is little chance that the cash will be returned to shareholders anytime soon, meaning there is excess cash in the company, but I wouldn’t consider net cash in any part of my valuation. The cash position should be considered when examining balance sheet strength though. Buying this company at 13 time average earnings is not cheap, especially considering how far away average is from here.

Jewitt-Cameron (JCT on TSX) was originally analyzed by Adam over at ValueUncovered here. JCT has also been extremely hard hit by the recession. The company usually carries some cash on the balance sheet, usually a couple hundred thousand, against revenue (usually) in excess of $50 million. Recently, the company has come into a large amount of cash. Given the fact that the company doesn’t carry much cash usually, and isn’t afraid to use short-term borrowings, I think it is safe to include all net cash as part of the valuation.

Westjet (WJA on TSX) has been mentioned before. The CEO said on a conference call that he thinks the company needs around 40% of revenues in cash on the balance sheet. I think he is being too conservative. I think it is more like 20%. I will have a more detailed post on Westjet shortly. I think you can include some of the cash as part of your evaluation as management seems to be able to deploy it at attractive rates.

Many investors love to use enterprise value (EV) in their valuation, myself included. EV is equity plus debt minus excess cash. But determining that cash part can be very tricky. Lets run some numbers to give you an example:

ABC is at $10, have sustainable earnings of $1, net cash of $5. Net cash P/E is 5. Very cheap. You could consider “fair value” at 10x earnings plus net cash, making $15 a target. You are buying at 67% of fair value. What if the company was like VLN, meaning there is cash, but you aren’t likely to see it. Your 10x earnings plus net cash now yields a $10 stock, or current purchase price. You have NO margin of safety. What if the earnings are $0.75 and the company has $7.50/share in cash. Fair value is still $15 (10x earnings of $0.75, plus $7.50 cash), but now the valuation is 50/50 business and cash. If you are not going to see that cash, then fair value moves to $7.50, meaning that buying at $10 gives you negative margin of safety. I think you get the point.

A big thing to consider is how much of fair value is cash and how much is earnings power. In the previous example, $15 fair value was 67% earnings and 33% cash. If fair value is mostly cash, then I think there is an added element of risk that isn’t discussed enough. Most of the value is cash, then a simple return to shareholders is best, but the company can go on an acquisition streak at the height of a leveraged economic expansion. Buying back your own shares at a huge premium to book or earnings is not accretive, yet most companies to just this. My point is the larger the cash portion is of the total valuation, the better the company should be at deploying that cash. Makes sense, right?

It is up to each investor to determine what exactly is excess in the excess cash calculation. It is easy to punch some numbers in a spreadsheet and have it spit out a fair value, but investing is an art not a science. Despite what many think, the market is pretty efficient, and it takes some pretty big extremes to get outsized returns with little work.


The author own share in WJA at time of writing, and would like to own shares of JCT (if it was cheaper).



Filed under Random Thoughts, Valuation examples

The Banks

The financial crisis was horrible for many. I definitely failed to realize how intertwined our financial companies were to the health of the economy. Given how many “experts” work for our regulators, it is very tough for me to even beleive that this kind of thing was possible. I know Wall Street is famous for creating bubbles, but I thought our central governments (on a global basis) would have been more in tune with what was happening.

I wanted to play a rebound in the banking sector. My thinking was to find some survivors and hold onto them until the financial markets stabilize. I wanted to be geographically diversified as each state has its own set of risks. Originally I was focusing on the upside and not the downside. This lead me to overpay for many of them.

The screening process started by typing in a few financial company metrics and ended up stumbling upon PlanMaestro over at Variant Perceptions (see blogroll). He has some excellent posts on financial company analysis here. All things considered, I would rather own a Canadian bank over the small regional banks in the States. Our banks have fared far better, but so have their share prices. During the height of the crisis, I put 15% of my portfolio into Canadian Western Bank (CWB on TSX). I knew they would survive, the question was would they have to do some major dilution to do so. Though it wasn’t the most undervalued company at the time, I thought the risk/reward proposition was in my favour.

I wanted to start with a quick screen:

  • Some insider ownership
  • NO insider selling
  • NPA’s stable of declining for at least 2 quarters
  • Good NIM, ability to earn their way out of trouble
  • Stable or improving Texas Ratio
  • Cheap on a price to book
  • Stable deposits
  • Not needing to dilute shareholders any further
  • 30-90 days past due are dropping

This meant I was likely to find companies who:

  • Took on TARP money
  • Share prices may have risen substantially already
  • Had headline risk as financial reform legislation was in progress
  • Share prices would be volatile

Of course, there was so many banks I didn’t know were to start. If you follow PlanMaestro on twitter, he talks about a few that he owns (or at least owned at the time). I picked the first 5 he mentioned and started researching.

For anyone who has not invested in bank stocks, they take a huge amount of time to research. Their 10-k and 10-q are very lengthy compared to many other companies. Enter Bank Reg Data. They have a huge database to help you crunch the numbers without combing trough enough reports to bury yourself. Best of all, the trial is free.

Since starting to “invest” in banks stocks, I have learned many things:

  • Their loan portfolio is a black box
  • Macro really matters
  • Sentiment really matters
  • There is an extreme amount of time required to properly understand just one company
  • Despite the problems in the industry, their executives get paid very well

I have decided to cut my losses and run. It turns out that my portfolio would be positive for the year without my US banks. I would also be outperforming my benchmark too.

Are there really cheap banks out there..Yes. Can I find them..Maybe. Will it be skill or luck…most likely luck. I don’t have an opinion on the sector as I don’t feel like I am well-informed enough to offer one. In order to manage 15% of my portfolio, I was spending over 50% of my time. There are going to be banks that double and triple, but if I can’t determine risk, I don’t feel comfortable. It is much easier for me to understand other companies and industries. There are other fish in the sea, and most of those fish didn’t need to take TARP money. Turns out I was speculating and not investing. Though I feel that normally (non-financial crisis world) I can understand a bank, the credit crunch threw too many unknowns in the picture. If capital needs to be injected, the common shareholder takes it on the chin.

Another thing that bugs me is that many bank executives still make a ton of money, despite the precipitous drop in their share prices.

You don’t have to make it back the same way you lost it.



Filed under Portfolio Performance