Follow the Cash

For many years, bankruptcy rates of companies on the major stock exchanges were so low you could count them on one hand.

Believe me, it wasn’t a sign that our business schools were getting better… or that our CEOs were getting smarter. Nor was it because of the salutatory effects of the Sarbanes-Oxley legislation back in 2002, which strengthened corporate accounting rules. Rather, it was because banks were lending to anybody and everybody. Such quaint notions as credit rating, future ability to pay, and current cash status were tossed out the window in a sea of greenbacks.

Banks had so much money to lend that even bottom-of-the-barrel borrowers were courted like princes.

And then – around October of last year – the credit crisis grabbed hold of the U.S. economy and hasn’t let go since. It is squeezing all the excess cash out of the financial system and then some.

Now, instead of banks begging for borrowers, potential borrowers go begging.

Need I say that money is the lifeblood of an economy? Bartering is popular along the China-Vietnamese border, from what I hear – but in this country, cash rules.

Show Me the Cash

If you can’t turn on the lights, you can’t make money. That’s the dark reality of a company unable to pay its bills. And without cash lubricating an economy, businesses dry up. I saw it happen in Asia (where I did a lot of business as CEO of a trading company) in the late 1990s. One by one, Asian currencies came under attack by aggressive currency traders. Local currencies quickly sank to one-half to one-fifth of their previous values.

Companies that had very manageable dollar-denominated loans were suddenly paying much more interest after converting their local currency to dollars in order to make the payments. Companies defaulted left and right as their debt burdens doubled… tripled… and quadrupled.

My customers were disappearing, and my unpaid receivables were piling up. It was a nightmare. I did the one thing I had to do for my business to survive. I found the biggest cash cow in Indonesia – Big Oil. Everything bought and sold in dollars… small debt… and lots of cash coming in daily from oil exports. I finagled a couple of small contracts… hung on for dear life… and eventually grew the business from there.

There weren’t many companies that had cash to spare in those days, but most of those that did survived and lived to see another day – and, a couple of years later, the country’s recovery.

It taught me a valuable lesson as a businessman and as an investor. Careful cash management is a critical tool in getting through an economic crisis. When hard times hit, those with cash have a leg up on those without.

Now that the U.S. is in the throes of multiple economic crises, I’m asking companies to show me the cash before I even consider investing in them. And for your financial security in 2009 and beyond, you should resolve to do the same.

Out of Cash, Out of Luck

GM is in dire need of cash. It was going to run out sometime early next year if it didn’t get an infusion from the government. Ford and Chrysler are standing shoulder to shoulder with GM in front of Congress, hat in hand. They got some money, but only enough to see them through the next three months or so.

Investing in cash-poor companies with a history of weak leadership and a demonstrated preference for making losses over profits isn’t my idea of smart investing. (Even if the auto companies get the $34 billion they’re asking for, who’s to say they won’t need another $34 billion a few months down the road?) But investing in the anti-GMs of the world is.

I’m talking about companies that make a lot of cash and have a lot of cash left over every quarter. Companies that also have demonstrated the ability to consistently produce profits over the years. And if these companies give dividends, all the better. You then get a tangible benefit as a result of their prudent cash-management ways.

The best thing about these companies is that their cash is your protection. As long as they have it, banks can’t force them into a premature foreclosure.

Finding the Corporate Deep Pockets

The best cash-protected companies are those that have no debt (like chip-maker Nvidia Corp.) or very little debt (like Intel, with $2.4 billion in debt compared to a market cap of $70 billion).

As you’d imagine, capital-intensive industries (like telecom and auto) rely more on debt than the high-tech industry (like chip and computer makers). Even well-managed capital-intensive companies will have higher debt numbers than most high-tech companies.

If that makes you uncomfortable, you’re in good company. The legendary investor Warren Buffett avoids capital-intensive companies even in the best of times because of their big spending needs and the extra risk that represents. And this is not the best of times.

We will see hundreds, if not thousands, of companies fail. It has already begun in the financial sector with Lehman and others going under. The “Detroit Three” could be next.

My favorite show-me-the-money metric is the price-to-cash flow ratio (P/CF). Cash flow should be at least 10 percent of price (the market capitalization of the company – share price times the number of outstanding shares available). For example, Verizon has a market cap of $87 billion and a cash flow of $27 billion. Its cash flow is 30 percent of its market cap. That’s very good. It beats the minimum cash flow I look for by three times.

Verizon’s total debt-to-equity ratio is 0.88 – quite low for a telecom company. This is a metric I use less frequently, but I mention it because financial search engines (like Yahoo’s) include it and they don’t include the P/CF. Just remember that the ideal debt-to-equity ratio varies from sector to sector and company to company. For high-tech, it should be below 0.5 (in general). For capital-intensive industries, a ratio above 2 isn’t considered high.

That’s why Toyota’s total debt-to-equity ratio of just above 1 is good. And so is Intel’s, with its miniscule debt and a total debt-to-equity ratio of 0.06.

Cash matters. But also notice that I’ve mentioned companies with very solid records of growing their profits. Verizon, Intel, Toyota, and Nvidia are taking their lumps now – but they all have smart management that has led them to the top of their industries.

Maybe that doesn’t make them the most exciting stock picks. But right now, the market is exciting enough, with its wild swings from week to week and day to day.

Investing in a company that has cash on hand and a nice cash flow doesn’t mean you get a company immune from those wild swings… or from seeing its markets shrink and its sales drop. But it does give you a company that won’t get ambushed by banks or its own excessive spending needs… so it can come out of the recession intact and primed for growth.

All you need to make this strategy work is an investing horizon of two years or more. If you’re under 60, such a horizon should be mandatory.

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Andrew Gordon

Andrew Gordon is a former editorial contributor for Early To Rise Investor’s Edition. He has 20 years of experience working in infrastructure and environmental projects around the world. When he wasn't traveling, he taught marketing and finance courses at the state university of Maryland. Mr. Gordon has authored several books for McGraw Hill and other publishing companies on energy markets, global countertrade practices and the hot growth sectors of China and Russia. He is also a top-rated speaker at financial conferences.