Years ago, I sponsored a debate between two prominent money managers about which measure was a better way to pick stocks – the price-earnings ratio or price-to-cash-flow ratio. The discussion got heated, and at times personal.
Most investors don’t take their stock-selection methods quite that seriously – especially if they don’t make their entire living in the market.
The truth is, there’s more than one way to find a great stock. Many methods are good and none is perfect. One good one involves stocks selling for a low multiple of free cash flow.
Cash flow is reported earnings minus certain intangible or special elements. In theory, this gauge tells you how much cash a business is generating.
About once a year, I devote a column to companies selling for a low multiple of cash flow. In 12 previous columns on this subject, the average 12-month return on my recommendations has been 24.4%, compared to 7.8% for the Standard & Poor’s 500 Index.
Ten of the 12 columns have beaten the index. Nine of the 12 have been profitable.
Bear in mind that results for my column picks are theoretical and don’t reflect actual trades, trading costs or taxes. The record of my column selections shouldn’t be confused with the performance I achieve for clients. And past performance doesn’t guarantee future results.
Last Year
Last year’s results were poor. Three of the five stocks I recommended declined, with the biggest loss, 48.3%, in PDL BioPharma Inc. (PDLI). HCI Group Inc. (HCI) and Valero Energy Corp. (VLO) also lost ground. AU Optronics Corp. (AUO) and eBay Inc. showed gains.
Overall, my picks were down 9.9% from August 18, 2015 through August 18, 2016. By contrast, the S&P 500 was up 6.6%.
What is Cash Flow?
To calculate cash flow, many people use a measure called EBITDA, which stands for earnings before interest, taxes, depreciation and amortization. It’s not that these four elements aren’t real, but they don’t always measure how robustly cash is flowing into a business or out of it.
Free cash flow is cash flow minus the level of capital expenditures required to keep a business going. Of course, there’s room for judgment and dispute about what that level is. In practice, analysts often use some kind of average figure for the previous few years as their gauge.
Now it’s time to venture some new picks.
Dillard’s
All department stores have been suffering from the onslaught of internet retailing (especially Amazon) and from strong competition from specialty stores. Dillard’s has suffered also from a lack of excitement and innovation.
Yet the chain, based in Little Rock, Arkansas, has a solid business. The stock sells for only five times cash flow and seven times free cash flow. A roster of several investors I respect has moved into the stock in the past two quarters.
Atwood Oceanics
Atwood Oceanics Inc. (ATW, Financial), mentioned recently in this column, is an offshore drilling company. That’s a feast or famine business, and lately it’s been famine to near the starvation point.
Atwood sells for about one times cash flow and 1.5 times free cash flow. Cash flow may well diminish next year but for patient holders, I think there will be substantial rewards in 2018 and beyond.
Lear Corp. (LEA, Financial), of TK Michigan, makes seating and electrical systems for cars. Investors worry about a slowdown in the world economy hurting car sales in Europe, China and even the U.S.
That’s why Lear stock sells for only six times cash flow and seven times free cash flow. At these multiples, I think it’s an attractive buy. In the past five years, the company has increased its revenue by an average of close to 17% per year.
Delta Air Lines Inc. (DAL, Financial) is a stock I recently sold for clients, because I wanted to trim clients’ exposure to the airline industry. (I still have other holdings in the industry.)
Why, then, do I mention it favorably here? Because Delta stock sells for less than five times cash flow and less than seven times free cash flow. It is very attractive on that basis.
Delta has one of the oldest fleets among major airlines, and that will require substantial capital expenses. However, the stock is attractively cheap.
Net 1 UEPS
As my most speculative pick, I’ll go with Net 1 Technologies Inc. (UEPS), which offers charge cards and payment processing in emerging countries. The company, based in Johannesburg, South Africa, has increased its revenue from less than $300 million five years ago to about $600 million now.
Net 1 UEPS trades for only four times cash flow and less than seven times free cash flow. It is also cheap by all of the other measures I normally use.
Disclosure: I own Lear shares for clients and personally.
