Let cash flow be a guide when buying stocks
Multi-millionaire Jerry Smith paid $200 million in cash to build a teddy bear factory five years ago.
Fortune smiled on the fictitious Mr. Smith. He now sells a million teddy bears a year at $40 apiece. The revenue for Smith's Fierce Bears Inc. is $40 million a year and his annual expenses are $15 million so he is pulling in $25 million a year in cash.
Reported profit, however, is only $5 million as he books $10 million a year in depreciation charges on the factory. In other words, his earnings are $5 million but his cash flow is $15 million. The $10 million difference is an accounting entry but not an expenditure of cash.
Which is the truer measure of the business' worth, earnings or cash flow? Analysts debate that point endlessly. Clearly, both measures tell you something important.
About once a year, I write a column recommending stocks that look attractive based on the ratio of the stock price to cash flow. This is the 10th such column. The previous ones appeared in August 1999-2006 and August 2012.
Of those nine sets of recommendations, eight beat the Standard & Poor's 500 Index, and seven were profitable. The average return for those nine columns was 28.6 percent, compared with 6.4 percent for the index. All figures include reinvested dividends.
Bear in mind that past performance doesn't predict future returns. The results for column recommendations are theoretical and don't reflect trading costs or taxes. And the performance of my column recommendations shouldn't be confused with that of actual portfolios I manage for clients.
Correction and apology: In past writings, I overstated by one year the total number of years in this series that were profitable. The confusion arose because I formerly evaluated results over several time frames. Now, I have standardized everything on a one-year basis.
Last year's recommendations did particularly well. From August 14, 2012, through August 14, 2013, they rose 82.5 percent, compared with 22.8 percent for the S&P 500.
All five selections beat the S&P. GameStop Corp. returned 194 percent; EPAM Systems Inc., 83 percent; National Western Life Insurance Co., 54 percent; JP Morgan Chase & Co., 50 percent; and Eli Lilly & Co., 32 percent. In simple terms and bluntly: Results this good are probably a result of luck, at least in part.
Several of those stocks have risen above my buy points, but I still recommend JP Morgan Chase and own it for some of my clients.
Here are some new selections. Each of these sells for less than eight times cash flow and less than 10 times free cash flow. Free cash flow is cash flow minus a company's actual expenditures for capital equipment and dividends.
MetLife Inc. (MET) is the largest life insurance company in the United States and has been profitable in nine of the past ten years. The stock seems bargain priced to me at about four times free cash flow and nine times earnings. Its bond portfolio will suffer from rising interest rates, but on the plus side, new premiums will be invested at higher rates.
KKR & Co. (KKR), also known as Kohlberg Kravis Roberts, is a financial firm famous for leveraged buyouts. It borrows money, takes companies private, tries to fix their flaws and make them more profitable, and then takes them public again. The dividend yield is more than 8 percent. I own it for one client at the moment, and may buy it for more clients.
Several refiners meet the price-to-cash-flow test I mentioned above, and look attractive to me. The largest, and probably the one with the strongest balance sheet, is Phillips 66 (PSX). It sells for seven times earnings and offers a dividend yield of about 2 percent, which in my opinion can and should be raised.
Archer-Daniels-Midland Co. (ADM), of Decatur, Ill., processes agricultural products and turns out profits with clockwork consistency. In the past 10 years, it has shown positive earnings every year, even during the 2007-2009 recession. The stock sells for 18 times earnings, which is above my normal range (15 or less). But it looks very cheap based on cash flow.
For my final pick, I suggest Western Digital Corp. (WDC), a stock I own personally and for almost all my clients. It is one of the two largest disk drive makers in the world. Investors fret that disk drives may be replaced with newer technologies. I think that is possible, but it will take a long time. In the meanwhile, Western Digital will see a lot of cash flow.
John Dorfman is chairman of Thunderstorm Capital LLC in Boston. He can be reached at firstname.lastname@example.org.