Small Stocks with Lots of Cash Win Big

10/15/2012 10:00 am EST

Focus: STOCKS

Marc Gerstein

Editor, Forbes Low-Priced Stock Report

After running some numbers, it looks like small companies with large cash positions seriously outperform their competitors in the intermediate and long term, reports Marc Gerstein of Forbes Low-Priced Stock Report.

With interest rates so incredibly low, we’ve often heard commentators and investors berating companies that hoard cash. “Buy back shares!” they say, or “Pay dividends!”...or something, anything, rather than accept next-to-nothing returns on their holdings. I’ve never shared such sentiments.

I’ve been in this business through four recessions plus some near-recession slowdowns, and I’ve done a stint as a junk-bond manager. As a result, I’ve come to admire companies that abjure the fad du jour and recognize and do what is right for their businesses, and that includes not just consideration of return on investment but also risk. And liquidity—i.e. lots of cash (net of long-term debt)—reduces risk.

That’s an especially big consideration for low-priced stocks, companies that are usually too small to benefit from the diversifying effect of a wide variety of businesses and the spreading of fixed costs over a wide revenue base.

I have nothing against share buybacks or dividends, and am happy to see them when they occur in connection with stocks I own. But I’m equally happy to see the cash just sit there, and preferably grow. That’s why you’ve often seen me make special, and favorable, mention of situations where net cash is a sizable portion of the share price. My theory is that when cash builds, good things happen to stockholders, even if we can’t predict or lock in on which particular good thing it is.

I tested that by checking the performance of a portfolio of stocks that pass the basic screen I use to create our Top 40, but confined to the top five—not on the broad-based multi-style ranking system I usually use, but the top five measured on the basis of net cash per share as a percentage of the stock price.

Over the past five years, a tough period that included the full extent of the financial crisis, the regular Top 40 turned $1,000 into $2,771 (while the Russell 2000 turned $1,000 into $1,050). The top five cash hoarders, on the other hand, turned $1,000 into $11,116! If you’re worried about the role of luck—a legitimate consideration with just five stocks—note that the top ten cash hoarders turned $1,000 into $6,123.

During the past 12 months, a very challenging period for low-priced stocks, the Top 40 turned $1,000 into $1,166, versus $1,222 for the Russell 2000. The top five cash hoarders rose to $1,214, and the top ten to $1,387.

Cash-rich companies work well generally, but the concept seems especially useful in our universe. Obviously, I’ll be doing more research in this area.

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