How to Spot Cash Cow Businesses for Your Stock Portfolio
My very first exposure to business financing was when my dad lent money to my uncle to start his new textile business. In return, my dad became a shareholder and when the business blossomed a few years later, my dad multiplied his returns many times over. There were other financing options my uncle could have used at that time, but getting help from relatives was definitely an easier option than taking a loan from the bank.
These are the two traditional types of financing most people are familiar with: You either raise capital from shareholders in the form of equity or you raise capital by borrowing from creditors (like banks) in the form of debt.
But as I continued on my journey as an investor, I discovered other ways that big, listed companies are using to finance their business – without having to rely on debt or equity. They are able to raise large amounts of working capital through the sheer efficiency of their business model. And if a company can raise large amounts of capital without the need for more debt or equity injections, it is a company I want to take a closer look at.
In my opinion, there are two other more “invisible” ways a company can finance their business: the customer and supplier.
If you have a business that is financed by its own customers, you’ve hit the jackpot. So how do a company’s customers actually help finance it? Let me explain.
When I bought my first insurance plan, I knew I was paying for a service I hope I would never use. But we all still buy insurance because we never know what might happen in the future. And while all of us are paying our insurance premiums year after year for a product we might never use, the insurance companies are raking in tons of cash from us, the customers, knowing they will never need to utilize all that cash at any one time. Because only a handful of people will claim for insurance at any one time, the rest of that money is essentially “free” for the insurance company to use. Similar to banks, insurance companies can use their customers’ money to profit through making loans and investments. To me, it is the ultimate form of financing.
Most people like us can’t possibly start an insurance company or a bank; they are highly regulated and sophisticated industries. But we are always welcome to buy stock in insurance and banking companies. The nature of their business has seen them last for many centuries; the products they sell are still pretty much the same a few hundred years ago. They will never go out of style.
So just how successful can investing in a good insurance company be?
Warren Buffett’s investment in insurance company, GEICO, was a home run and made him billions of dollars in returns. Shelby Davis, maybe the best investor you’ve never heard of, started off with $50,000 in 1947 and by the time of his death in 1994, ended up with a net worth of $900 million! Similar to Buffett, a portion of Davis’s portfolio consisted of banks and insurance companies.
But you don’t always have to be a bank or insurance company to gain financing from customers. Other businesses have also successfully created their own model of customer financing.
For example, Starbucks with its Starbucks loyalty card has found a way to reward its customers while collecting cash from them upfront. When you prepay for your drinks on a Starbucks card, Starbucks receives money from you, the customer, in advance which they can use to better finance their working capital.
Another example: Jobstreet Corporation Bhd, a job agency company listed on Bursa Malaysia, collects upfront fees from employers for its recruitment services every month. These monthly upfront fees (differed income on the balance sheet) have grown from a modest RM5.8 million in 2005 to a monster RM40 million in 2012! Founder and CEO, Mark Chang, uses this money to invest and produce higher returns for shareholders. Since its IPO, Jobstreet’s market capitalization has multiplied thirteen fold to RM1.5 billion today. It is a brilliant example of innovative management finding ways to maximize returns for the company and its shareholders.
Besides customers, suppliers can also help with a company’s financing.
When a supplier agrees to deliver inventory to you today but accepts payment up to three months later, then you essentially you’re getting three months of free financing for that order!
Many businesses essentially receive some form of credit terms from their suppliers, so it’s nothing especially new. But when you combine it with a robust business model of collecting payment from customers fast, it becomes pretty remarkable.
In the F&B industry, BreadTalk may receive up to 90-day credit terms from most of its suppliers. At the same time, they receive cash immediately when customers shop at their bakeries or dine at their restaurants. They also collect rent upfront from their tenants in Food Republic and advance deposits from franchising as well. Putting everything together, Breadtalk has a fantastic business model where they can collect cash up front and wait to pay their suppliers till three months later. Breadtalk should never face any financing issues with its working capital.
On the flip side, to be a business which needs to wait 90 days to get paid is a nightmare. One example: Construction companies that rely heavily on government spending. The bureaucracy involved at government level means construction companies usually have to wait a long time for to collect payment for their projects.
Having said that, I don’t want to paint all construction companies with the same brush. Some might have great working capital models with their suppliers and customers. Usually by glancing through a company’s financials, we can easily tell who has the better financing terms and the higher bargaining power in the value chain. Only a few companies with high bargaining power can craft out special credit terms with its suppliers. Look around and I am sure you will spot them.
A note of caution: longer payable days doesn’t always mean a company has higher bargaining power with its suppliers. From my experience, a typical business arrangement with its supplier usually stretches out up to 150 days. Anything longer than that is beyond the norm and subject to questioning.
The fifth perspective
Like I’ve mentioned earlier in this article, if you can spot a company with a great working capital model that essentially gets their customers and suppliers to “fund” their business operations and growth, you definitely want to take a closer look at the company.
A company with a low working capital ratio could have trouble meeting its short-term obligations and in the worst case scenario face bankruptcy. A company with a high working capital ratio usually means it has a very robust and efficient business model that is able to collect money fast: a cash cow business. If the company’s management is savvy enough to invest its excess cash to generate higher returns for shareholders, you might be looking at the next high-growth stock in your portfolio!