What do you want in your portfolio if you're a long-term investor?

Cash cows.

These are companies that:

  • send a high percentage of each dollar in sales straight to the bottom line;
  • show big cash flows even after investing in their own businesses; and
  • earn top returns on that reinvested capital.
  • When you find one, hold on until the cash starts to dry up. Each year you own one of these cash cows, you multiply your returns as the business generates a flood of cash and then reinvests that to earn a mouth-watering return. It's called compounding, and it works even more powerfully when the return on reinvestment is 15% than when it's 2% on a savings account.

    How do you find cash-cow stocks for the long run? One way is to do a top-down analysis of long-term trends and the companies likely to benefit from them.

    That does the job, but unless you have an advanced degree in obscure stocks, any top-down list is likely to include a high percentage of the usual suspects like Cisco ( CSCO) and Intel ( INTC).

    But I've used a screen to find 10 cash cows for long-term investors that aren't on most investors' radar screens, and that yield even more cash flow and reinvest it even more profitably than either Cisco or Intel.

    In fact, those two stocks didn't make my final cut for this screen. They weren't quite profitable enough.

    My 10 cash cow winners are:


    Moo Money
    These companies generate lots of cash that flows to the bottom line
    Company Industry Market Cap
    ($ Billions)
    Return on Equity (5-Year Average) Return on
    Invested Capital
    (5-Year Average)
    Alcon (ACL:NYSE) Medical instruments $17 NA NA
    EnCana (ECA:NYSE) Oil and gas 18 NA NA
    H&R Block (HRB:NYSE) Tax preparation and financial services 8 27% 18%
    Harley-Davidson (HDI:NYSE) Motorcycles 15 24 20
    Landauer (LDR:NYSE) Radiation monitoring 0.3 45 45
    Mentor (MNT:NYSE) Medical appliances 1 17 17
    Paychex (PAYX:Nasdaq) Payroll and human resource services 14 31 31
    SEI (SEIC:Nasdaq) Asset management 4 53 45
    Strayer Education (STRA:Nasdaq) Education services 1 54 54
    Wrigley (WWY:NYSE) Chewing gum and candy 10 27 27
    Source: MSN Money

    How do these companies generate this kind of return on their investments -- and produce the rivers of cash that they can then reinvest at these rates of return?

    The formula isn't exactly a secret; it's just very tough to execute. And you need three conditions to be in place:

  • the business needs a base of recurring revenue so it doesn't have to replace its customers every quarter;
  • the business must be relatively easy to expand with the addition of capital; and
  • the business still commands high margins because the company has built significant barriers to competitors moving into the field.
  • Block Is the Textbook Case

    Tax-preparation giant H&R Block ( HRB) is a classic example of that. Establishing a national brand name and opening enough offices to create a national presence requires a big initial outlay of capital that's likely to deter competitors. That stage of the business isn't especially profitable. The company has to build up the infrastructure to track and recruit tax preparers, train them to a single company standard, and have them file and manage the tax returns themselves.

    But once the company has spent the money to create that national scale, cash begins pouring through the doors. The national presence is itself a huge marketing plus, and the company's scale makes H&R Block one of the few tax preparers able to amortize advertising across a national system of offices.

    Expanding the business requires incremental capital to open a new office and hire new staff, but it doesn't require much new spending on the infrastructure of the business itself. While Block is best-known for its tax service, it has diversified its portfolio of businesses over the years, and its revenue now comes from a variety of financial services.

    In the fiscal year that ended in April 2003, H&R Block recorded $3.3 billion in revenue. Cash flow from operations came to $691 million, or 21% of sales. Free cash flow was $388 million, or 12% of sales. Revenue has grown at an average annual rate of 21% over the last five years and earnings per share at an average of 18% a year.

    The stock is up an average of 14.5% annually over the last five years.

    The business model at Wrigley ( WWY) is almost identical, even though the company sells gum rather than tax-preparation services. Wrigley continues to rely on chewing gum to generate the bulk of its revenue, and its dominant market share lets the company outspend and outdistribute its competitors. But this spending is actually at a very low cost per package of gum because the company's base of sales is so large: $2.8 billion in gum, which is Wrigley's trailing 12-month sales figure, is a lot of gum.

    And it creates a lot of cash flow. Operating cash flow over the trailing 12 months was $405 million, or about 14% of sales. Free cash flow came in at $206 million, or 7% of sales. And remember that Wrigley paid a dividend of 88 cents a share, for a yield of about 1.6%, over that period as well.

    Sales have grown at an average of 7% and earnings an average 8% annually over the last five years. That rate has picked up lately to 12% for sales and 14% for earnings in the last quarter on a year-to-year comparison.

    Show Me the Money

    How did I pick these 10 stocks? By saying "show me the money" over and over again. Here are the standards I used.

  • Companies need to have cash in the bank. For starters, these companies had to have cash on their balance sheets equal to 5% of the value of their assets. There's nothing like starting with a pile of cash if you're looking for evidence that a company can generate lots of cash.
  • Free cash flow is growing. Then, a company had to show growth in free cash flow over the trailing 12-month period, and free cash flow had to amount to more than 5% of sales in each of the last three years. That way, I could be certain that the money from sales was dropping to the bottom line in something like the financial equivalent of a flood rather than a trickle.
  • Big returns on equity. And then, to make sure that all of this cash was being reinvested at a high return, I looked for a trailing 12-month return on equity that was greater than the average for the company's sector. I also required that any company show a return on equity of 13.75% or better, so sectors with low return-on-equity rates across the board couldn't put lots of companies on this list. That would put the company in the top 25% of all companies on this measure of profitability. And just to make sure I leveled the playing field between companies that use equity and debt financing, I also required companies to show a return on assets of 5.05% or better -- enough to rank them in the top 25% of companies on that measure too.
  • Not too small -- and not too big. And finally, to make sure that these stocks had enough liquidity to make them reasonable investments, I eliminated all stocks with a market capitalization of less than $203 million. (That's the cutoff for the smallest 25% of all market capitalizations.) And finally, to make sure I turned up unfamiliar names, I ruled out any stock with a market capitalization above $20 billion.
  • Two Tests to See If the Screen Makes Sense

    I got validation for this screen -- and the strictness of its requirements -- by watching some of the stocks that investors use as their benchmarks of profitability fail to clear the hurdles I've put in place. As I noted, neither Intel nor Cisco made the list. These two extremely profitable companies dominate their markets but aren't quite profitable enough. Recent return on equity has been "just" 12.7% at Intel and "just" 12.8% at Cisco Systems.

    The screen also gained credibility with me because it managed to pick up many of the most profitable and well-known stocks. At least until the last step when I ruled out the biggest and most familiar stocks above $20 billion in market capitalization. As they should, the big drug companies showed up in force on my list of cash cows: Eli Lilly ( LLY), Merck ( MRK) and Johnson & Johnson ( JNJ) all made it to the last cut. So did Dell ( DELL), Microsoft ( MSFT) and Nokia ( NOK) from the technology sector.

    As always, please remember that screens like this are just a starting point for doing due diligence on a stock. They're not a substitute for digging into the guts of a company.

    But they do provide a guide for what to look for in stocks that work. Just keep saying "show me the money" as you look for true cash cows for the long run.

    At the time of publication, Jim Jubak owned or controlled shares in Microsoft and Paychex. He does not own short positions in any stock mentioned in this column. Email candidates for the Clean Stocks list to Jim Jubak at jjmail@microsoft.com.