Warren Buffett used to define a "margin of safety" as a company that was trading close to - or even below - "breakup value."
Of course, that metric doesn't work as well today - especially in the parts of the tech sector that we like to focus on: You just aren't going to find many high-growth companies trading at bargain-basement levels.
But with U.S. firms sitting on a record $1.7 trillion in cash, you can find some name-brand tech firms whose cash reserves can cover a decent portion of their share price - creating a nice "margin of safety" as we move into the fall. (Good timing, considering everything that's happening - or not happening - in D.C. right now.)
I like to refer to these as "Cash is King" tech stocks.
So let's look at three that even Buffett, who typically avoids this sector, would consider...
Why Cash Is Important Now
If you've followed Strategic Tech Investor, you know I put a lot of stock in my five-part strategy for finding high-growth stocks at the lowest-possible levels of risk.
That strategy is why, in fact, that I believe "the road to wealth is paved by tech."
And Rule No. 1 - which tells us that "great companies have great operations" - addresses this very situation. That rule tells us to focus on cash flow and profit margins and is the key part of a system that I've used for decades.
Companies that are sitting on a lot of cash provide a big margin of safety against a market decline. They give investors confidence that the company is on the right track and will succeed over the long haul. And that's why investors are less likely to sell in a panic at the first sign of trouble.
This isn't all about sentiment, either. Solid cash flow is a great way to lower what I consider to be the "true cost" of buying a stock. There's even a simple mathematical formula for figuring this out. Simply take the stock's "sticker price" - what it's selling for - and subtract its net cash per share.
Let me show you what I mean.
Let's say a stock is trading at $24 a share. But the company holds net cash of $6 a share. That means that your true cost is closer to $18.
In other words, if the company liquidated tomorrow (outside of bankruptcy court), as a shareholder you're entitled to that $6 a share because it's your money.
It's just like getting the stock at a 25% discount.
And that's an implied margin of safety.
And here's another great thing about cash-rich tech leaders. They can use that money to do three things that will only benefit you as a shareholder.
The company can:
- Pay dividends or increase the payout ratio.
- Buy back shares, a move that can push the stock higher on its own.
- And buy other firms in a way that can improve future growth and help the company expand into new markets.
With strong cash flow as our guide, let's take a look at three tech firms that have a huge amount of cash on hand already - and are most likely to add to their war chest with the hefty cash flows they generate.
The Internet Killer
Cisco Systems Inc. (Nasdaq: CSCO) is a big-cap tech leader that throws off a tremendous amount of cash. Then again, it's a leader in the web-based technology that is integral to today's tech-centric world.
The company sells the routers, switches, servers, optical components, and wireless controllers used to access the web and manage its content.
As a result, Cisco is targeting the high-growth market for the "Internet of Everything" (IoE). Simply stated, the Internet of Everything means that nearly every single object in the world will be connected via wireless chips and sensors to a vast computer network. Cisco CEO John Chambers says the IoE market will create a global supply chain that will generate $14 trillion in profits.
Cisco already has strong financials. For fiscal 2013, Cisco's earnings rose 24% on a year-over-year basis to $10 billion. And the fiscal year's fourth quarter represented the 10th in a row with record earnings, which were up 18%.
More to the point, Cisco generates about $8.6 billion in free cash flow (FCF) a year. It's now sitting on net cash of $34 billion, or about $6.30 a share. With a share price of $24.30, that gives us a "true cost" of about $18 - and a 25% "safety margin."
Chambers is using some of that cash to flesh out Cisco's franchise. He recently agreed to buy cybersecurity firm Sourcefire Inc. (Nasdaq: FIRE) for $2.7 billion. Last week, Chambers announced Cisco is buying WHIPTAIL, a maker of solid-state computer memory systems, for roughly $415 million.
Hard Cash at "Mr. Softy"
Another cash-rich heavyweight - and one that's been making headlines of late - is Microsoft Corp. (Nasdaq: MSFT).
Flush with cash, Microsoft recently said it's buying Nokia Corp's (ADR) (NYSE: NOK) devices and services business for $5.2 billion plus $2.2 billion in licensing fees.
The idea is simple - Microsoft is way behind in the mobile tech sector and needs to make a bold move to become a serious player. And now that CEO Steve Ballmer has announced his retirement, the software giant is about to embark on a turnaround plan. I expect that to include more acquisitions into areas with much greater growth than the stagnant PC market.
Microsoft has strong financials and a fortress balance sheet. In its recently concluded fiscal year, Microsoft reported an impressive $21.86 billion in net profits on revenue of $77.85 billion. The firm knows how to make a buck - it boasts operating margins of 34% and a return on equity (ROE) of 30%.
Talk about a mountain of cash...
Microsoft brings in $19 billion a year in free cash flow. At the end of June, it had nearly $60 billion in net cash and equivalents on its balance sheet. With a market cap of $273 billion, Microsoft trades at about $32.65. But it has net cash per share of $7.23. That lowers our true cost of buying the stock to $25.42 - creating a 20% margin of safety.
Mega-caps aren't the only companies that generate a lot of cash.
As Seen on TV
Take a look at Ambarella Inc. (Nasdaq: AMBA), a fast-moving, small-cap firm that is focused on the rapidly emerging market for ultra-high-definition televisions (UHDTV).
The company specializes in making semiconductors for high-resolution video cameras used in sports, which will be an early adopter of this technology that makes video images at least four times sharper than today's UHDTV.
Ambarella recently introduced a new chip for the consumer-digital-video market for what are called "4K cameras." The firm is already known for supplying chips used in wearable high-def video cameras like those that skiers attach to their helmets.
Founded in 2004, the firm went public in October 2012 at $6 a share. Today, the stock trades at about $19.90 a share - a 231% gain. Focused on a growth market and generating so much cash flow, Ambarella still has plenty of room to run.
With a market cap of $548.73 million, the company has zero debt and is sitting on nearly $190 million in cash. That means Ambarella has a net cash per share of $6.89. So your true cost of buying this stock is closer to $13 a share - meaning you can look at the current share price as "hiding" a 25% "discount" ... or a 25% "margin of safety."
So we've given you three cash-rich companies that also feature good businesses. That should translate into some big growth potential in the long run - and a limited downside during the uncertain stretch ahead.
And that's a formula that you have to like a lot ...