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Choose cash cows when buying bargains

Globe and Mail Update

If you're anything like me, you're giving your investment account statement a wide berth these days. Being reminded of how much money you're down is more painful than remembering the time you came out of the restroom with your shirt tucked into your underwear.

Assuming everyone feels that way, though, it is precisely the time you should be looking to buy shares. Indexes are down 30, 40, even 50 per cent, earnings estimates are being slashed (and probably have more room to fall), the headlines are as encouraging as an autopsy report and deleveraging, judging from the shrinking hedge fund universe, will soon be mostly over. Maybe there's more value to be shed, but we are much closer to the bottom than the top.

But you don't want to buy stocks willy-nilly. Just because a stock is down 80 per cent doesn't make it cheap. The worst culprits are resource companies that borrowed money to build a mine or some other form of production, assuming higher prices. The economics of those projects don't make sense any more and the banks, who lent the money, are calling the loans and, soon in some cases, the shots.

What you do want, first and foremost, is earnings stability – a long history of it, which suggests a long future of it. You also want companies with that X factor that helps them withstand competition, which can get ferocious when economies stall and competitors get aggressive about gaining market share. Able management is an obvious requirement, as is a modest amount of debt relative to earnings. Firms that meet all these requirements will share one trait: They'll crank out plenty of cash for their shareholders and, even if they don't grow quickly, if you get them at a good price you'll get your return – in time – from valuation rather than growth.

Let's look at a few examples. WD-40 Co. makes that lubricant spray you'll find a can of in every garage. It also makes 3-in-One, the oil your dad used to put on your bike chain (or that you put on your kid's bike chain). The company's been around forever and, like Xerox and Google, its main brand is occasionally used as a verb, as in “WD-40 it.”

There's nothing stopping bigger competitors from making a rival product. They've tried, but they've never really succeeded. WD-40's return on equity averages somewhere in the high teens, but the company generally carries a lot of cash on the balance sheet, which lowers returns because cash doesn't earn anything to speak of. The company has $42-million (U.S.) in the bank now, versus a market capitalization of $445-million. Long-term debt is only $32-million.

Valuation-wise, WD-40 is quoted at an earnings yield (per share profit divided by stock price) of 7 per cent versus 10-year Treasuries of less than 2 per cent. Earnings are a little volatile because the inputs for the products are commodities (like petroleum) and steel. Fiscal 2008 saw a drop in profit for those reasons, but long-term earnings grow about 5 per cent a year. Finally, the company pays a dividend for a better than 3-per-cent yield and buys back stock every year (almost 3 per cent of it last year, for example).

Avon Products Inc. is another possibility. It earns more than 60 per cent on equity and, unlike WD-40, does so by running a lean and leveraged balance sheet. Still, debt, at $1.7-billion, doesn't seem too onerous based on the company's long history of increasing profits, which run at about $900-million. Yes, a recession bites into sales of beauty products but we're not buying for the short term and a downturn is, at least partly, baked into the stock's valuation, which looks good at less than 10 time estimated earnings, even if they do prove optimistic.

Procter & Gamble Co. is another interesting name. Over the past decade, the company has increased earnings per share by 12 per cent a year. Those earnings, as you'd expect, have been very stable. After getting kicked in the teeth Tuesday with a more than 4-per-cent drop, P&G's shares can be had for less than 15 times earnings. That doesn't seem like much for a piece of one of the world's most eminent owners of consumer brands, including Gillette, Duracell, Pampers and more.

These companies, and likely their shares, should do well over time, but what's more important is that they demonstrate the bargains available to investors when the herd stampedes away from the market.

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