The Market's Capital Opportunities

The Market's Capital Opportunities By Tim Hanson (TMF Mmbop) Since the beginning of 2006, I've been mildly obsessed with studying the top stocks of the past 10 years. I've reached two conclusions: It pays to look at small caps. Management matters. Small companies with superior CEOs will give you a head start on market-beating returns, but I thought there would be more indicators. So far, I've been wrong. The quandary of cash Before starting my analysis, I hypothesized that profits 10 years ago would correlate with returns. They don't. I also thought that strong balance sheets 10 years ago would correlate with returns. Nope. That shocked me. I was taught to look for small caps with substantially more cash than debt. Yet on my list of the 100 top small caps of the last decade, there's no evidence that a company's cash/debt position matters. Here's a sampling: Company 10-Year Return* Cash/Debt in 1996 Panera Bread (Nasdaq: PNRA) 1,379% $6/$73 Expeditors International (Nasdaq: EXPD) 2,036% $37/$0 Ross Stores (Nasdaq: ROST) 1,188% $24/$46 Hovnanian Enterprises (NYSE: HOV) 1,203% $10/$253 J. Jill (Nasdaq: JILL) 2,038% $4/$4 Jabil Circuit (NYSE: JBL) 2,607% $6/$26 QLogic (Nasdaq: QLGC) 3,252% $8/$0 * January 1996 through December 2005. Data courtesy of Capital IQ, a division of Standard & Poor's. A few have lots of cash and no debt, others are dollar for dollar, and still others have substantially more debt than cash. Debt diligence Like me, many individual investors out there are wary of debt. Sure, it's nice for a company to have more cash than debt, but debt is not evil. A lot of times, companies take on debt for less than the cost of equity -- and when a company can earn more that the cost of servicing its debt, that's a moneymaker right there. The key is to look at a company's cash/debt position in context. Why does a company have so much cash or debt? What is it planning to do with it? What are the costs? What are the potential returns? Homebuilder Hovnanian Enterprises used its debt to add inventory and fund financing operations. Both endeavors have worked out quite well. Moreover, today much of the company's debt is financed at reasonable terms and due years from now. Logistics expert Expeditors International, on the other hand, has never carried much debt. It has been able to fund its incredible growth predominantly through cash from operations.