first majestic silver

Cash Return on Investment

August 24, 2003

Nowadays, by far the majority of articles published in the investment media have to do with "Capital Gains" or "Capital Appreciation". Look for articles on "Cash Return on Investments" and you will probably find yourself on a fruitless quest. Whilst every investor is beset by this problem, no one seems to be talking or writing about any practical solutions.

What the heck. It's Saturday and it's cold and raining outside. Let's have a go.

A few years ago (in 1998 to be precise) I looked around at the financial environment and posed the question: "When the economy eventually tanks - and capital values implode - where will one get cash flow?"

At that time, P/E ratios of Nasdaq companies seemed to be heading for the stratosphere, and the oxygen saturation level of P/E ratios of most Dow and S&P companies was also too thin to sustain the viability of these equity markets without artificial life support.

As it turned out, artificial life support was forthcoming. The Fed provided a ventilator. Not only did the ventilator deliver pure oxygen in the form of loose money policy, but the anaesthesiologists (initially the Clinton administration and later the Bush administration) also arranged for the delivery of analgesic and paralysing gases. Undetectable by the untrained eye, these anaesthetic vapours numbed the patient's senses, rendered investors immobile, and the markets survived for two more years. The Nasdaq "zombie" overshot the stratosphere and eventually landed up in outer space but, unfortunately, it failed to break free of Earth's gravitational pull.

The mainstream equity markets also topped out in 2000 - as evidenced by the breakdown of a Diamond Reversal Pattern on the Dow Industrial Index Chart - and a Primary Bear Market was called under Dow Theory when the Dow Industrial Index and the Dow Transportation Index both began to manifest a sequence of descending lows.

So, surveying the landscape in 1998, what was a reasonable (risk averse) investor to do?

Unhappily, the question was more oriented to cash flow than to capital gains. Had it been "capital gains" oriented, I might have seen the coming Bull Market in Treasuries. However, because I was focussing mainly on "superior" cash returns, I completely missed that opportunity. Such is life.

But I had done some other in-depth research and thinking, and had come up with a fascinating discovery:

P/E ratios of privately owned, unlisted businesses appeared to be living in a Parallel Universe. At the very small end of town, individual businesses were (and still are) changing hands at multiples as low as 1.5 X - 2.5 X pre tax cash flow before owner's drawings. It was, literally, unbelievable!

There were two discrete opportunities that flowed from this discovery:

  • From a Financial Engineering perspective, there appeared to be a cornucopia of arbitrage opportunities if one channelled one's thinking into "Industry Rationalisation" mode. By merging several small businesses at (say) 4 X P/E, one could create one large business at (say) 20 X P/E. I soon rejected this approach as being too theoretical, because a key to successful outcomes of this type of M&A activity is "Management", and the egos of little emperors (small business entrepreneurs) are typically too large to accommodate a Management Team outcome. In any event, where would the CEO come from? It was all too hard.
  • There was a clear (and relatively uncluttered by competition) opportunity to target those industries that seemed strategically most likely positioned to withstand a recession and to see if small, cash positive businesses could be grown into big cash positive businesses within those industries.

The industries that seemed to me then (and are still to this day) most likely to be recession proof are as follows:

Those that offer "low dollar cost" indulgences: Confectionery, Ice Cream, Coffee, Donuts, Cookies, Cinematographic Entertainment (movies, videos, DVDs), Cosmetics, Costume Jewellery, etc. The rationale here is that when times are tough, and people can't afford the big ticket indulgences anymore, they will turn to small ticket indulgences to stave off depression and insanity. (As an aside, a subsidiary opportunity of aligning with these "small business" opportunities has to do with "Franchising" - which is a vehicle for turning the small opportunity into a large one)

Those that provide physical necessities and that are also impervious to low cost imports from low wage countries. In this area, I could only come up with two target industries, namely freshly prepared food and the sex industry. (The mind boggles at the thought of a franchised chain of outlets in the sex industry) 80% - 90% of all hospital related expenditure in the average person's life occurs from the age of 65 onwards. An ageing population will not postpone illness during a recession. To the contrary, the stresses of a recessionary environment are likely to exacerbate needs on a personal medical level. "Alternative Medicine" pills and potions (as opposed to pharmaceuticals - which is BIG business), medical technology, medical and alternative medicine services all seem to offer opportunities.

Waste Reclamation. The old saying "where there's muck there's money" remains a truism, and probably increases in strategic relevance in a recessionary (cost conscious) environment. One problem with these industries, though, is that they are typically populated by "godfather" oriented individuals who are predisposed to want to fiercely protect their family's turf. However, for the brave hearted, there is a massive and chronically unsatisfied need to reclaim old motor car tyres, and also industrial heavy metal effluent that may seep into the waterways. (There are many technological solutions available to address these two needs, but no one - to my knowledge - has yet worked out how to make serious money from them)

There are other industries that seem to offer significant opportunity in tough economic times. Most of these are related to "Economic Infrastructure" - where the Government is the ultimate customer - but these are either populated by huge organisations (high P/E ratios) or, in the case of small businesses, are typically cash strapped. These industries are the ones that most Venture Capitalists conventionally target anyway because they are typically technology oriented and, for the sake of completeness, the list is reflected below (Note that these businesses will have prohibitively high P/E ratios if quoted on Nasdaq, and will be exponentially more fraught with risk, if not). They are:

Technologies and/or industries that support the road grid, rail grid, water and sewer pipe line grids, and electricity power line grid

Non chemical Water Treatment industry (Ultra Violet, Ozone, Silver based biocides, Reverse Osmosis, other Micro Filtration)

Alternative Energy (Wind, Solar, Ocean Wave Movement, Various Gas-to-liquids technologies, various Fluidised Bed or other technologies which facilitate incineration of low calorific solid fuels such as Municipal Garbage)

Personal and Mass Transportation (Fuel Cells, Mag-Lev trains) Note: Fuel Cell technology will require active.

Government Intervention before it can become commercially relevant because there will be billions of dollars required to roll out a "distributed" refuelling capability throughout the country.

Environment Beneficiation (Re-forestation, soil enrichment programs, Solid Waste (sewage) reclamation)

  • Education
  • Telecommunications technologies
  • Information Technologies

Neither of the above lists is exhaustive, but there appears - today - to be only four generic opportunities for investment which offer reasonable cash returns, and where the capital value of the investment will likely ALSO be preserved over the long term.

These are:

  • A portfolio of small businesses in the FIRST list of industries as itemised above (preferably under a Franchisor/s umbrella - so as to minimise risk)
  • Information Technology businesses that support a portfolio of such investments (probably "dot.net" based to allow for remote access - via the internet - of a central data base)
  • Un-leveraged, Revenue Producing Real Estate - where today's typical (un-leveraged) 9% return on investment may fall to (say) 4.5% if the buildings remain only 50% tenanted
  • Precious Metal Miners - whose cash flows are likely to turn strongly positive as the "after-burner" effect of rising precious metals prices kicks in.

In the case of 4 above, "time" is a potential enemy - because the timing of the anticipated (serious) rise in precious metals prices is too difficult to call, and cash flows will likely remain tight until the markets start to run. For this reason, it is advisable to be circumspect about investing in undercapitalised mining businesses - which are likely to become takeover fodder in the event they run out of capital.

The "safest" Precious Metals Mining investments are those that are well capitalised because THEY are the one's most likely to be the predators.

In Gold, the largest is Newmont
In Silver, the two best capitalised are SSRI and PAAS.

Of course, those investors who keep a portion of their investment portfolio in Cash or short term Treasuries will find themselves being offered wonderful bargains in the years ahead but, as always, timing will be the issue. In the meantime, it may pay to keep some of one's powder dry - even if the environment turns inflationary.

To counter-balance this latter inflation related risk, an investment in "hard assets" is the logical way to go, and there is no shortage of this type of asset - many of which have been languishing . Unfortunately, few are likely to generate a Cash Return. For this reason, the counterbalancing element of the portfolio that is dedicated to combating inflation should be made up of a combination of precious metal mining shares already referred to, AND precious metals themselves, as well as other hard assets.

Of course, this article reflects the Saturday morning ruminations of one individual and should not be interpreted as Investment Advice.


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