There is something so tantalisingly tangible about cash that it is hard not to be tempted by the idea of investing in businesses that are flush with the stuff. And it's these types of businesses that my stock screen focuses on this week.
Despite the allure of cash, though, the use of cash-based valuation techniques is far less common than earnings-based analysis. Given that cash is the lifeblood of any business, this seems somewhat counterintuitive; even more so considering that earnings numbers are so easy to present in an advantageous light and even to out-right fiddle. But in the hands of a good finance director, the malleability of earnings numbers can actually be used to everyone's advantage by presenting a calmer and fairer narrative about a company's progress than that which could be gleaned from the rather lumpy and erratic figures found in most cash-flow statements.
Both earnings and cash-based valuation techniques have advantages and drawbacks. But perhaps one of the biggest advantages of looking at cash when it comes to stock screening is that it is a measure of value that the rest of the market does not pay very much attention to. Indeed, a slightly skewed approach to value hunting is often the best way to find real bargains.
The cash-based valuation measure that this screen looks at is the enterprise value-to-free cash flow (EV/FCF) ratio, which is also often referred to as a free cash-flow yield when free cash flow is expressed as a percentage of either enterprise value or market capitalisation. I use enterprise value rather than market capitalisation for my ratio because it takes account of the level of cash and debt held by a company, which seems particularly pertinent when conducting a cash-based screen. While the EV/FCF criteria in itself is not too stringent (the ratio simply needs to be lower than the median average) I have put in place several other tests to try to assess the quality and consistency of cash generation.
One of the big advantages of investing in companies that throw off a lot of cash is that there should be plenty of money to invest in growth and return to shareholders. So this screen has a second valuation criteria, which looks at what is returned to shareholders through dividend payments. Namely, a company's shares need to boast a yield that is among the top third of all dividend-paying shares screened.
This was one of a number of changes I made to the screen last year to try to sharpen its focus on value. The changes were significant enough that I am not producing the cumulative performance data that I normally would based on the results of the screen since its inception (2011 in this screen's case). From a cosmetic point of view, that's a bit of a shame because the screen was performing pretty well before the changes. Fortunately, the revamped screen also put in a good performance in its first year, delivering a total return of 16.5 per cent compared with 6 per cent from the FTSE All-Share (see graph).
Source: Thomson Datastream
The result from the screen was pretty good on a stock-by-stock basis, too, with six of the nine shares selected outperforming the market. And Games Workshop was the only share to actually post a negative total return - albeit quite a hefty minus 23.6 per cent (see table).
| Name | TIDM | Total return (17/09/13 - 16/09/014) |
|---|---|---|
| Chesnara | CSN | 36.3% |
| WH Smith | SMWH | 31.6% |
| Micro Focus | MCRO | 30.7% |
| TalkTalk Telecom | TALK | 26.0% |
| HomeServe | HSV | 24.6% |
| Aberdeen Asset Management | ADN | 16.8% |
| British Sky Broadcasting | BSY | 4.5% |
| BBA Aviation | BBA | 1.5% |
| Games Workshop | GAW | -23.6% |
| Average | - | 16.5% |
| FTSE All-Share | - | 6.0% |
Source: Thomson Datastream
Following last year's screen overhaul, I haven't done too much tinkering this time around. One change I have made, though, is to screen FTSE All-Share stocks separately from the combined constituents of the FTSE All Small and FTSE Aim All-Share indices. This has been done to generate a decent selection of small-cap picks, which were somewhat lacking from last year's screen. The screening criteria are:
■ FCF higher than it was five years ago and rising in at least three of the last five years;
■ Cash generation (cash from operations/operating profit) of over 100 per cent in at least two of the last three years;
■ Cash profits of at least two times net debt;
■ A return on equity of 10 per cent or more;
■ EV/FCF ratio below the median average;
■ A dividend yield in the top third of all dividend-paying shares.
Nine stocks passed all the tests. I have provided write-ups of the investment cases for the five highest yielding of the shares below. The other four are detailed in the table that follows.
Nine high-yield free cash-flow kings
