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Criteria for Investing in Negative Free Cash Flow Stocks

December 13, 2012 | About:
I previously wrote about a controversial topic: investing in highly geared stocks. Today's topic is equally challenging; most value investing disciples will conveniently avoid stocks with negative free cash flow. As usual, there is always this little grey area for me where it comes to contentious issues such as buying stocks with negative free cash flow.

My criteria for considering stocks with negative free cash flow includes the following:

Positive Operating Cash Flow with One-Time Capex

Some companies may have consistent operating cash flow but have negative free cash flow in certain years, as they invest in capex to renew their plant and equipment. The nature of capital expenditures is a distinguishing factor in cases like this. Firms with recurring high maintenance capital expenditures should be avoided.

Companies in the Growth Stage with Future Free Cash Flow

While companies listed on the stock exchange are of a certain size, there are many of them still in the growth stage. It is understandable for such growth companies to invest heavily for future growth and generate negative free cash flow as a result. The key to analyzing such companies is to first ensure that they earn above their cost of capital; growth destroys value when the return on invested capital is below the cost of capital.

Cash Users with Asset Growth

Companies typically fall into one of the two categories: cash users and cash cows. The former category includes shipping, property developments and industrials, which need and use infinite amounts of capital. The latter category includes services, retail and distribution companies which throw off lots of cash flow each year. The cash users typically deliver negative free cash flow every year as they need to invest in capital expenditures to maintain and grow their business. In the case of the cash users, their value resides in the growth in assets, not free cash flow generation.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He publishes value investing case studies, investment checklists, and potential stock ideas on the Cheapskate Investing blog. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website

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