(By David Brickell) Companies that produce increasing amounts of free cash flow can be naturally attractive to investors in search of stocks that are capable of funding future growth on their own. This bargain stock screen looks for investment candidates that are valued attractively against their free cash flow.
In business education 101, the importance of free cash flow can hardly be overstated. Calculated by taking cash from operations and subtracting capital expenditure, the FCF shines a light on a company's current cash position. Warren Buffett famously refers to it as "owner earnings".
As opposed to traditional earnings, which may reflect sales that have yet to be paid for (depending on payment terms with customers), FCF reflects the real cash picture. To illustrate that point, it is possible for a company to produce positive earnings but negative FCF. Likewise, a company can be unprofitable but still have a positive cash flow. Neither is particularly desirable without the other over protracted periods, but without cash flow to pay bills, the company will likely be out of business fairly soon. Comparing the difference between the two is the basis of our very successful Accruals screen.
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Free cash flow as an indicator in the search for stocks is particularly popular among bargain investors because it can offer a greater degree of accuracy in establishing a company's intrinsic value – its real value as opposed to its market value. While other measures such as assets and earnings can ultimately be understated or even manipulated by crafty management, FCF is more transparent.
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Using free cash flow as a valuation metric is a central philosophy of Bruce Berkowitz, a star fund manager at the US-based Fairholme Fund. His adherence to the bargain investing philosophies of Benjamin Graham sees him focus on companies with good management, positive free cash flow and are cheaply priced. Describing his approach, he claimed: "At Fairholme Fund, our trademark is we ignore the crowd. So we pay attention to what matters and what matters is cash. We count cash, ignore the crowd."
How it works
The Free Cash Flow Cows screen looks for cash rich companies growing their FCF, yet selling at a cheap multiple to FCF. The screen is inspired by a methodology developed by Jae Jun on the excellent Old School Value US blog, who advocates the use of FCF for the intrinsic valuation of a company. That approach looks for stocks that are cheap on an Enterprise Value to Free Cash Flow basis but consistently growing their FCF, which should in turn lead to improving valuations. You can also see another interesting US screen variant here.
Traditionally, cash cows tend to be larger, slow-growth companies with dominant market positions. They throw off lots of cash with which they can reinvest in future growth or pay dividends to investors. The nuance with the Free Cash Flow Cows screen is a focus on companies that are increasing their free cash flow, reducing debt and boast relatively attractive valuations on an EV to FCF basis. This means that smaller stocks (that are potentially cheap to buy) are more likely to qualify for the screen.
We have modelled the Cows screen for UK stocks, selecting companies where the EV / FCF ratio is less than 10, where the ratio of FCF to long term debt is falling and where FCF has been increasing over the previous three years. To add an extra layer of comfort and attempt to strip out rogue results, we also look for companies where FCF is more than 5% of sales revenue. Companies are then ranked on EV to FCF.
Does it work?
Stockopedia's Free Cash Flow Cows screen is currently among our better performing Bargain investing strategies, with a year-to-date return of 17.5% versus 4.4% for the FTSE 100. Elsewhere, Old School Value's backtesting of its FCF Cows screen found that the technique beat the Samp;P 500 in six out of nine years between 2001 and 2009. Between 1999 and the end of 2007, Berkowitz's FCF-focused fund produced an average annual return of 17.40% versus 1.71% for the Samp;P 500.
Watch out for
Screening the market for companies trading on a low FCF multiple can reveal bargain stocks where valuations are on the rise. However, investors should beware that using established ratios like Price-to-FCF can risk identifying stocks where share prices have fallen for other reasons – leading to a potential value trap. Using EV to FCF unhooks the market cap but the smaller nature of the stocks on the screen means great care and further analysis are needed.