Cash is probably the one word that can describe my investing strategy. A focus on cash dominates every investment and piece of investment analysis I conduct as it is the single most important factor to consider when assessing a business’ survivability.
Unlike profits, cash flows cannot be manipulated at the stroke of a pen, and even if they are questions will be asked when the company’s balance sheet does not match up. What’s more, unlike profits, cash flow goes straight to the bottom line.
A substantial free cash flow also gives a company financial flexibility. The business can invest how it sees fit, return capital to shareholders and pay down debt without any constraints. A lack of cash flow forces a company to make hard choices that may not be the best for all stakeholders involved, such as delaying payments to suppliers, extending debt maturities or selling off productive assets to raise money.
Moving onto the balance sheet, with a hefty cash balance and limited leverage, a company is not dependent on the capital markets. If leverage is high, and a firm depends on the kindness of banks or bondholders to lend it money to keep the lights on, once again options are limited, and during periods of market turbulence, management may find creditors are no longer willing to support the business.
What investors think about cash
Some of the world’s most renowned value investors have also proclaimed their love of cash over the years, and for this article, I have gathered a selection of quotes from these investors that explain, better than I ever could, the importance of cash in investing:
From Seth Klarman (Trades, Portfolio):
"Investments throw off cash flow for the benefit of owners; speculations do not. The return to the owners of speculations depends exclusively on the vagaries of the resale market.”
From Michael Burry:
“How do I determine the discount? I usually focus on free cash flow and enterprise value (market capitalization less cash plus debt). I will screen through large numbers of companies by looking at the enterprise value/EBITDA ratio, though the ratio I am willing to accept tends to vary with the industry and its position in the economic cycle."
From Glenn Greenberg:
"I tend to focus on free cash flow. We basically looked at the amount of cash that the business could return to us as shareholders and valued that."
Wallace Weitz:
“We approach valuation from a perspective similar to that of a 100% owner – what are the excess cash flows we will receive in the future and how certain are we about their durability?"
Warren Buffett (Trades, Portfolio):
"Common yardsticks such as dividend yield, the ratio of price to earnings (P/E) or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business."
Charlie Munger (Trades, Portfolio):
“There is a class of business where the eventual 'cash back' part of the equation tends to be an illusion. There are businesses like that – where you constantly keep pouring it in and in, but where no cash ever comes back; struggling with a business that never produces any cash – whether it's winning or losing as a matter of accounting – is no fun. You should seek businesses that just drown in money if they just pause for breath.”
Mohnish Pabrai (Trades, Portfolio):
“We want to basically count the cash. For example many people want to look at free cash flow. They will not deduct capital expenses from it. So this goes back to the Patel, Dhandho mentality which at the end of the day is 'What’s in the register?' So what I always ask myself is what’s in the register the end of the year after everything’s done. You’ve paid the taxes and you have the capital expenditures. What’s in the register at the end of the next year and the year after? In general that is a metric that I use – what’s in the register? Because different businesses are different, you might have to get to that register number in different ways. I’m focused on the idea that you have some black box that generates some cash. What is that cash and what is the consistency of that cash over time? Then we can put a multiple on it and take it from there. So that’s generally how I go about it.”
Bill Ackman (Trades, Portfolio):
“I think the job of a security analyst is to take the reported GAAP earnings of a business and translate them into what Buffett calls owner earnings. I call them economic earnings. The next step is to assess and understand the durability of those earnings. Fundamentally, what you’re looking for is how much cash the business can generate on a recurring basis over a very long period of time.”
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