Investors are often told to look for companies that have a "strong balance sheet," and one of the measures they often use is the ratio of long-term debt to stockholders' equity. Unfortunately, Schwab research has found that such debt ratios of little use as stock selection tools.
Historically, stocks with little or no long-term debt have not outperformed market averages. Not surprisingly, the stock market is generally too efficient to reward metrics in such widespread use.
But that's not to say that balance-sheet strength is irrelevent for stock selection. An alternative indicator that many investors tend to overlook is a company's cash liquidity level as an indicator of future returns.
The ratio of cash and marketable securities to market capitalization as a measure of balance-sheet strength is simple and intuitive, but apparently not fully appreciated by the market. Among the 3200 largest U.S. companies (excluding financial firms, whose cash balances are largely offset by short-term liabilities), a simulated portfolio containing the 5% of stocks with the most cash have historically delivered an annual buy-and-hold return of about 24% versus 14% for the average stock ranked over the period 1986-2005. While past returns don't guarantee future results, the potential power of this simple indicator is intriguing.
One note of caution in researching the investment merits of firms with lots of cash on the balance sheet: it's critical to understand where the cash came from. The Statement of Cash Flows (found in a firm's annual 10-K report) is a great tool for this purpose because it reveals the sources of recent changes in a firm's cash balance.
For example, a firm generating positive cash flows from operations is preferable as this is a sign of a healthy business. On the other hand, a firm whose high cash balance stems from recent financoing efforts such as share offerings or debt issues, or from investing activities such as the sale of a business unit, is much less interesting as these sources of cash flow tend to be one-time shots.
-- Greg Forsythe, On Investing Magazine, Fall 2005
The article goes on name several stocks worthy of further research, all of which have positive and growing cash flow from operations: ASF, AET, AGYS, IMN, SFA (Scientific Atlanta has since been acquired by Cisco), UNTD.