Cash-rich companies find favour in testing times

Healthy net cash position acts as an insurance against the demand downcycle

Healthy net cash position acts as an insurance against demand downcycle. VISHAL CHHABRIA & RAM PRASAD SAHU write

The benchmark indices are down 28 per cent over the last month and the downward trend, which started towards the end of February, is expected to continue. The disruption caused by the Covid-19 pandemic has brought business to a standstill and this is well reflected in the high-frequency data, such as auto sales which have fallen through the roof.

The sudden disruption has led to a sharp correction in valuations. While the trailing priceto-earnings ratio for the Nifty is at a six-year low, the same on a price-to-book value is the lowest in the last 11 years. Though valuations across sectors have corrected sharply, given the uncertainty and limited visibility on revenues, market experts advocate a 'safety first' approach.

One way to limit the downside and navigate the demand volatility is to look at cash-rich companies. Analysts believe that cash-rich corporates will be able to withstand pressure on revenues, rise in costs, and dip in demand much better than companies which are struggling on this front.

While all companies will face the heat of demand destruction, those which dominate their respective industries and have a healthy balance sheet can handle the storm better. They are also in a strong position to capture growth opportunities once normalcy returns.

Manish Sonthalia, head of portfolio management services, Motilal Oswal Asset Management Company, says: “This tsunami will take down many companies with it. To tide over this situation in the best possible way, a company needs adequate liquidity and access to capital, should be a structural growth story, and most importantly have zero leverage.”

The reason many experts underline the need for investors to focus on cash-rich companies is the worry that the unprecedented crisis the global economy faces could have an impact extending beyond the short term. Ajay Bodke, CEO & chief portfolio manager (PMS), Prabhudas Lilladher, says: “Even after the lockdown is lifted, consumption and demand across sectors could be hit. So, cash-rich companies would be in a better position to manage their operations and fixed costs.” Companies have to pay suppliers to remain in continuity. This is where the cash comes handy, says Sonthalia.

In addition to cash on the books, investors should look at metrics, such as interest coverage and the cash burn ratio (operating cash flow after working capital changes).

Given the need for low leverage and healthy operating cash flows, Naveen Kulkarni, CIO of Axis Securities, prefers FMCG, telecom, and pharmaceutical companies as they are seeing relatively steady demand for their products and services. He prefers to avoid companies in the banking and financial services space and the real estate sector because of concerns on leverage and ability to manage their cash flows.

Needless to say, analysts prefer to stay away from global and domestic cyclicals as these typically face either a problem of debt, cash flows, or uncertain growth prospects. While some analysts believe that software plays are good bets, Jpmorgan expects the sector to be impacted given potential demand shocks from Covid-19 spreading to key client markets of the US and western Europe, an oil price shock, and potential impact on global growth. Bodke says investors should avoid companies in sectors such as aviation, hotels, multiplexes, travel, luggage makers, besides vulnerable NBFCS and banks.

To arrive at cash leaders, we not only looked at absolute cash equivalents (cash & bank balances plus investments) but also the excess cash the business generates consistently after accounting for its operating expenditure. Further, given the need to keep the leverage to a minimum, debtequity ratio of less than 0.5 was considered. Moreover, companies that have delivered less than 20 per cent return on equity were excluded.

In the recent correction, investors, too, have shown their preference for companies which have a strong track record,

lower risk to their earnings, and boast of healthy net cash positions. Vinod Sharma, head of capital markets strategy, HDFC Securities, says: “Cash-rich companies are made for this kind of a market. When market conditions are bad, stocks of cash surplus companies tend to fall by a less margin and whenever the market turns around, they bounce back faster.” Among the few caveats is that investors should ensure that there are no pledges on shares of promoters.