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Jubak's Journal
Recent articles:
• My 10 stocks for the next 10 years, 10/17/2003
• State Street, Intel point to continuing rally, 10/16/2003
• 8 great blue chips youve never heard of, 10/14/2003
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| | Jubak's Journal
10 big, fat cash cows
Long-term investors live to discover these companies, which generate lots of cash that flows to the bottom line and generates even bigger returns.
By Jim Jubak
What do you want in your portfolio if youre a long-term investor?
Cash cows.
These are companies that
- Send a high percentage of each dollar in sales straight to the bottom line.
- Show big cash flows even after investing in their own businesses.
- Earn top returns on that reinvested capital.
When you find one, hold on until the cash starts to dry up. Each year you own one of these cash cows, you multiply your returns as the business generates a flood of cash and then reinvests that to earn a mouth-watering return. Its called compounding, and it works even more powerfully when the return on reinvestment is 15% than when its 2% on a savings account.
How do you find cash-cow stocks for the long run? One way is the kind of top-down analysis of long-term trends and the companies likely to benefit from them that I outlined in my Oct. 17 column My 10 stocks for the next 10 years. That does the job, but unless youve got an advanced degree in obscure stocks any top-down list is likely to include a high percentage of the usual suspects. Was anybody really surprised to see Cisco Systems (CSCO, news, msgs) and Intel (INTC, news, msgs) on my list of 10 stocks for 10 years?
But Ive used a screen to find 10 cash cows for long-term investors that arent on most investors radar screens and that yield even more cash flow and reinvest it even more profitably than either Cisco Systems or Intel. In fact, those two stocks didnt make my final cut for this screen. They werent quite profitable enough.
My 10 cash cow winners are:
| 10 stocks that are true cash cows | | Company | Industry | Market cap ($ billions) | Return on equity (5 yr. avg. | Return on invested capital (5 yr. avg.) | | Alcon (ACL, news, msgs) | Medical instruments | $17 | NA | NA | | EnCana (ECA, news, msgs) | Oil and gas | $18 | NA | NA | | H&R Block (HRB, news, msgs) | Tax preparation and financial services | $8 | 27% | 18% | | Harley-Davidson (HDI, news, msgs) | Motorcycles | $15 | 24% | 20% | | Landauer (LDR, news, msgs) | Radiation monitoring | $0.30 | 45% | 45% | | Mentor (MNT, news, msgs) | Medical appliances | $1 | 17% | 17% | | Paychex (PAYX, news, msgs) | Payroll and human resource services | $14 | 31% | 31% | | SEI (SEIC, news, msgs) | Asset management | $4 | 53% | 45% | | Strayer Education (STRA, news, msgs) | Education services | $1 | 54% | 54% | | William Wrigley Jr (WWY, news, msgs) | Chewing gum and candy | $10 | 27% | 27% |
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How do these companies generate this kind of return on their investments -- and produce the rivers of cash that they can then reinvest at these rates of return?
The formula isnt exactly a secret -- its just very tough to execute. And you need three conditions to be in place:
- The business needs a base of recurring revenue so it doesnt have to replace its customers every quarter.
- The business must be relatively easy to expand with the addition of capital.
- The business still commands high margins because the company has built significant barriers to competitors moving into the field.
Block is the textbook case
Tax-preparation giant H&R Block (HRB, news, msgs) is a classic example of that. Establishing a national brand name and opening enough offices to create a national presence requires a big initial outlay of capital thats likely to deter competitors. That stage of the business isnt especially profitable. The company has to build up the infrastructure to track and recruit tax preparers, to train them to a single company standard, and to file and manage the tax returns themselves.
But once the company has spent the money to create that national scale, cash begins to pour through the doors. The national presence is itself a huge marketing plus, and the companys scale makes H&R Block one of the few tax preparers able to amortize advertising across a national system of offices. Expanding the business requires incremental capital to open a new office and hire new staff but it doesnt require much new spending on the infrastructure of the business itself. While Block is best-known for its tax service, it has diversified its portfolio of businesses over the years, and its revenue now comes from a variety of financial services.
In the fiscal year that ended in April 2003, H&R Block recorded $3.3 billion in revenue. Cash flow from operations came to $691 million, or 21% of sales. Free cash flow was $388 million, or 12% of sales. Revenue has grown at an average annual rate of 21% over the last five years and earnings per share at an average of 18% a year.
The stock is up an average of 14.5% annually over the last five years.
The business model at William Wrigley Jr (WWY, news, msgs) is almost identical, even though the company sells gum rather than tax-preparation services. Wrigley continues to rely on chewing gum to generate the bulk of its revenues, and its dominant market share in that market lets the company outspend its competitors and outdistribute them. But this spending is actually at a very low cost per package of gum because the companys base of sales is so large -- $2.8 billion in gum, which is Wrigleys trailing 12-month sales figure, is a lot of gum.
And it creates a lot of cash flow. Operating cash flow over the trailing 12 months was $405 million, or about 14% of sales. Free cash flow came in at $206 million, or 7% of sales. And remember that Wrigley paid a dividend of 88 cents a share, for a yield of about 1.6%, over that period as well.
Sales have grown at an average of 7% and earnings an average 8% annually over the last five years. That rate has picked up lately to 12% for sales and 14% for earnings in the last quarter on a year to year comparison.
The many ways to show me the money!
How did I pick these 10 stocks? By saying Show me the money over and over again. Here are the standards I used.
- Companies need to have cash in the bank. To start with, these companies had to have cash on their balance sheets equal to 5% of the value of their assets. Nothing like starting with a pile of cash if youre looking for evidence that a company can generate lots of cash.
- Free cash flow is growing. Then, a company had to show growth in free cash flow over the trailing 12-month period, and free cash flow had to amount to more than 5% of sales in each of the last three years. That way, I could be certain that the money from sales was dropping to the bottom line in something like the financial equivalent of a flood rather than a trickle.
- Big returns on equity. And then, to make sure that the all this cash was being reinvested at a high return, I looked for a trailing 12-month return on equity that was greater than the average for the companys sector. So that sectors with low rates of return on equity across the board didnt wind up putting lots of companies on this list, I also required that any company show a return on equity of 13.75% or better. That would put the company in the top 25% of all companies on this measure of profitability. And just to make sure that I leveled the playing field between companies that use equity and debt financing, I also required companies to show a return on assets of 5.05% or better -- enough to rank them in the top 25% of companies on that measure too.
- Not too small -- and not too big. And finally, to make sure that these stocks had enough liquidity to make them reasonable investments, I eliminated all stocks with a market capitalization of less than $203 million. (Thats the cut off for the smallest 25% of all market capitalizations.) And, finally, to make sure I turned up unfamiliar names, I ruled out any stock with a market capitalization above $20 billion.
2 tests to see if the screen makes sense
I got validation for this screen -- and the strictness of its requirements -- by watching some of the stocks that investors use as their benchmarks of profitability fail to clear the hurdles Ive put in place. As Ive noted above, neither Intel nor Cisco Systems made the list. These two extremely profitable companies dominate their markets but arent quite profitable enough. Recent return on equity has been just 12.7% at Intel and just 12.8% at Cisco Systems.
The screen also gained credibility with me because it managed to pick up many of the most profitable and well-known stocks. At least until the last step when I ruled out the biggest and most familiar stocks above $20 billion in market capitalization. As they should, the big drug companies showed up in force on my list of cash cows: Eli Lilly (LLY, news, msgs), Merck (MRK, news, msgs) and Johnson & Johnson (JNJ, news, msgs) all made it to the last cut. So did Dell (DELL, news, msgs), Microsoft (MSFT, news, msgs) and Nokia (NOK, news, msgs) from the technology sector. And a surprising but interesting name, Rio Tinto (RTP, news, msgs), the global mining giant, showed up from my top-down list of 10 stocks for 10 years.
Sometimes top down and bottom up analyses actually do meet.
As always, please remember that screens like this are just a starting point for doing due diligence on a stock. Theyre not a substitute for digging into the guts of a company.
But they do provide a guide for what to look for in that work. Just keep saying show me the money as you look for true cash cows for the long run.
New developments on past columns
State Street, Intel point to continuing rally
IBMs (IBM, news, msgs) earnings, coming on Wednesday a day after Intel (INTC, news, msgs) reported, left analysts and investors scratching their heads. After Intel beat estimates on earnings and revenue for the third quarter and then raised projections for the companys fourth quarter, IBM reported disappointing revenue numbers for the quarter and sounded remarkably wishy-washy about the fourth quarter. At $21.5 billion for the third quarter, IBMs revenue was below Wall Street expectation of $21.9 billion. And taking out the effect of acquisitions and currency translation pretty much wiped out any growth for the quarter.
Which raises an important question: did Intels strong report signal a strong upturn in the technology business or are IBMs much-weaker results a truer picture of the sector? Do we throw out the numbers from Intel or those from IBM to figure out the trend line? More earnings reports this week will help fill in the empty spaces on the graph.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET.
At the time of publication, Jim Jubak owned or controlled positions in the following equities mentioned in this column: Microsoft, Paychex, and Pfizer. He does not own short positions in any stock mentioned in this column.
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