“Scalpel please, nurse. Clamp … sponge.”
A surgeon needs a variety of instruments. Investors should use a variety of tools, too.
One tool that is underutilized by individual investors is the price/cash flow ratio.
How cash flow works
Cash flow attempts to measure the actual money coursing through the arteries and veins of a business. Some analysts consider it synonymous with EBITDA — earnings before interest, taxes, depreciation and amortization.
“Earnings” are profits. “Before” in this context means “disregarding.”
Interest is a function of a firm’s financial structure. Taxes are a function of its regulatory environment. They don’t measure the strength of the underlying operating business.
Depreciation and amortization are accounting entries that often don’t reflect actual cash receipts or expenditures.
That’s why, to measure a business’s “cash flow,” analysts add back those four items to reported earnings.
Many analysts go a step further and measure “free cash flow.” They subtract the capital expenditures (such as new planes for an airline) necessary to keep a business going.
Cash flow is especially important to companies looking to acquire other companies. Once the whale swallows the minnow (or vice versa), variables such as interest and taxes may change radically. What the acquirer cares about is the strength of the business itself.
Every August from 1999 through 2006 and from 2012 to the present, I’ve written a column on stocks that look good based on price to cash flow. The average return on those 15 previous columns has been 19.4%.
That dwarfs the 8.4% average return on the Standard & Poor’s 500 Index over the same 15 periods. Eleven of the 15 columns have been profitable and 10 have beaten the index.
Last year, no dice. I had one small gainer and four losers, for an aggregate loss of 11.8%. The S&P 500 meanwhile gained 2.5%. My biggest loser was Molson Coors Brewing Co. (TAP), down 23%.
Bear in mind that my recommendations are theoretical and don’t reflect actual trades, trading costs or taxes. Their results shouldn’t be confused with the performance of portfolios I manage for clients. And past performance doesn’t predict future results.
Here are a few stocks that look good to me now, based on price to cash flow.
Charles Schwab Corp. (SCHW) is one of the most successful discount brokerage houses in the U.S. Its book value (net worth) has grown with great consistency, increasing 12% to 13% in the past year, the past five years, and the past decade.
Schwab shares sell for about six times free cash flow. By contrast, the average stock these days sells for about 18 times free cash flow.
Holly Frontier Corp. (HFC), based in Dallas, operates refineries in Kansas, New Mexico, Oklahoma, Utah and Wyoming. Its stock price has fluctuated wildly the past six years, but shown no net progress.
There’s not much growth here, yet this is a solid business. It has shown an annual loss only once (2016) in the past 15 years. The company is known for its ability to process heavy oil (dense high-sulfur petroleum) into gasoline, jet fuel and other products. The stock sells for five times free cash flow.
RMR Group Inc. (RMR), based in my hometown of Newton, Massachusetts, manages more than 1,500 real-estate properties and also operates real-estate investment trusts.
The stock has been publicly traded for only a few years. It did well initially but has fizzled in the past 12 months. Yet earnings have grown nicely. The shares sell for four times free cash flow.
Xerox Holdings Corp. (XRX) shares rose 43% this year through August 26, making it one of the market’s best-performing stocks. The company, which used to be the monarch of copiers and printers, has been striving to reinvent itself.
It now gets most of its revenue from servicing office machines, but it also venturing into new areas such a 3-D printing. With so much uncertainty surrounding it, the stock sells for only six times free cash flow.
Warrior Met Coal
Coal mining is a buggy-whip industry, doomed to obsolescence. But it still supplies a good many U.S. power plants, and the industry will take a long time to die.
In the meantime, some coal stocks are so cheap that I believe they are good buys, even though the long-term outlook looks bleak. One that is quite cheap is Warrior Met Coal Inc. (HCC), which sells for 2.2 times free cash flow.
Disclosure: I changed my mind about Molson Coors in recent months. A fund I manage now has a short position on it, betting on a decline. I have no positions for myself or clients in the other stocks mentioned today.
John Dorfman is chairman of Dorfman Value Investments in Newton Upper Falls, Massachusetts, and a syndicated columnist. He can be reached at email@example.com.