The key to making money on the stock market is not a hugely complicated trading strategy requiring terabytes of computing power. It is simply searching for companies that are able to generate sustainable long term value though cash generation and simple business models. This requires several things, the most important of which is an operation that will run itself. The ‘key man’ risk is an important thing to consider here.
Take MasterCard Inc (NYSE:MA), for example. The company does not require one man to make the decisions, the company will run itself on a day-to-day basis, as long as people are using the company’s network. The same can be said for companies such as Philip Morris International Inc. (NYSE:PM) and DirecTV (NASDAQ:DTV), both companies that run themselves, unlike the crumbling empire of former billionaire Eike Batista, which depended upon his guidance and control to manage the business.
Having said that, Philip Morris International Inc. (NYSE:PM) is still subject to the declining tobacco volumes worldwide, putting a cap on overall growth.
Mastercard Inc (NYSE:MA), DIRECTV (NASDAQ:DTV) and Philip Morris International Inc. (NYSE:PM) all have one thing in common: their cash generation with relatively little effort. MasterCard, for example, achieves a cash conversion ratio of 64%, converting 64% of EBITDA into free cash. DirecTV converts 35% of EBITDA into free cash and Philip Morris converts 60% of EBITDA into free cash. Remember, this is almost without any effort.
Generating cash is good but shareholder value is better
Of course, it is all very well making lots of cash, but it is harder to turn this into shareholder value. Fortunately, the three companies above do this very well.
DIRECTV (NASDAQ:DTV) is using its cash, along with additional borrowing at record low rates, to buy back huge quantities of stock. The company is now reducing its issued share capital by around 100 million shares each year, or 15%, indicating that even without any income growth, the company’s EPS will expand around 15% per year. DirecTV has no need to spend heavily for growth, its cash flow is already enough to ensure long term value creation.
Mastercard Inc (NYSE:MA) is in the same position. The company is generating a huge free cash flow with a large profit margin (40% net), removing the need for heavy spending on growth. MasterCard also has an oligopoly over the global payment market with Visa, the two companies dominate the market and do not need to spend on capex to market their brands.
For the second quarter, Mastercard Inc (NYSE:MA)’s revenue only grew 10.5% and net income also expanded 10.7%, indicating widening profit margins as income grows faster than revenue. Cash flow from operating activities was $1.6 billion. Capex was $100 million, leaving a free cash flow of $1.5 billion.
Mastercard Inc (NYSE:MA) spent $1.3 billion repurchasing stock, buying back 1 million common shares during the quarter. Over the last year, MasterCard has bought back 3 million shares, 3.3% of common stock outstanding without borrowing cash, keeping its balance sheet clean. With such a strong free cash flow and investor returns, the company’s stock price is set to move infinitely higher for a long time to come.
Investors could be concerned about the EU cap on card fees. While these concerns are well founded, Mastercard Inc (NYSE:MA) is growing rapidly in Africa, which should offset some declines in Europe.
Of course, American Express Company (NYSE:AXP) produces the same kind of long term value creation as Mastercard Inc (NYSE:MA), but the company also has a degree of risk, which comes in the form of its lending to customers. This could lead to defaults during times of economic stress. That said, this has not been a significant issue for the company in the past, and during 2012, the company had a cash conversion ratio of 86% as cash flowed in from the company’s lending, services and transaction network.