What investors need to know about companies with high cash flows

The simplistic solution is that companies should reinvest in initiatives that will lead to growth.

Before focusing on so-called growth capital, many companies (and their shareholders) would do well to revisit whether enough is being spent on maintaining their status. There are countless examples of companies that have underinvested, resulting in a slow deterioration of their competitive position that usually culminates in some event requiring a big uplift to recover.

The Qantas case

Qantas is an example. Shareholders should take equal responsibility along with the management. Even if analysts note that stay-in-business capital appears to be lagging, the share price is rarely punished – indeed, the opposite occurs as companies are rewarded with a short-term increase in the return on assets.

The problem with investing in adjacent businesses is that these infrequently deliver the same return on assets as the core one. Investors often have a low tolerance for such endeavours as they can consume too much management effort for low marginal returns. A trickle of small acquisitions is frequently followed by a quiet realisation some years later.

Investors rarely like big acquisitions. There are few bargains, given that the targets arm themselves with a cacophony of advisers to maximise the price. The reality is that a large-scale purchase invariably takes time to prove its worth.

CSL arguably offers the most reassurance locally, considering its decent record, but it is a rarity. Regrettably, few Australian companies have succeeded in their global aspirations unless these have been an integral part of the business from the start. Among the many reasons is the mindset built around the local operations, which may not apply to other domains. Unique competitive conditions, consumer behaviour, operating requirements and management ethos mean domestic dominance is worlds away from being able to be replicated elsewhere.

The obsession with high returns on assets and huge free cash flow becomes unstuck without clarity about the consequences. Critically, one would want a much more careful examination of the reinvestment into the core. Cost-cutting or delaying on the basics could be one of the bigger flaws in corporate capital allocation.

Bucketing companies into three profiles summarises the possibilities:

• Low-return-on capital companies can pay high dividends but are usually unreliable. These are tactical-only options for those who spot the pattern.
• High-return companies typically burn cash in their start-up phase and then the question of cash application plus PE rating sustainability arises. Ideally, they have an ecosystem around which they can aggregate further growth – Apple being a classic example.
• The middle ground usually encompasses businesses with a smaller competitive advantage. They need to contain their pricing to head off others with similar positions and might need to invest more to remain relevant, while at the same time delivering a decent return on assets.

Although investment risk often refers to macro conditions, it is the risk that capital value is undermined by poor allocation decisions that may be the greatest problem.