They say cash is king and my free cash flow kings screen can certainly lay claim to a crown having produced a total return from nine stocks over the past 12 months of 22.8 per cent compared with a negative 3.2 per cent from the FTSE All-Share. This is the second year I've run the screen in a revamped format, which puts more emphasis on dividend yield. On a cumulative basis over the two years the screen has delivered a total return of 43.8 per cent compared with 2.5 per cent from the index. If a 1.5 per cent dealing charge is factored in, the return drops to 39.5 per cent.
FREE CASH FLOW KINGS 2014-15 PERFORMANCE
| Name | TIDM | Total return (23 Sep 2014 - 16 Sep 2015) |
|---|---|---|
| Redde | REDD | 141% |
| Centaur Media | CAU | 40% |
| 888 | H888 | 38% |
| Dillistone | DSG | 9.4% |
| API | API | 8.9% |
| Grafenia | GRA | 2.5% |
| Mitie | MTO | 0.5% |
| J Sainsbury | SBRY | -14% |
| ITE | ITE | -22% |
| Average | - | 23% |
| FTSE All-Share | - | -3.2% |
FREE CASH FLOW KINGS CUMULATIVE TOTAL RETURN
Source: Thomson Datastream
Many consider cash be the acid test of a company's financial health and the value of its operations. While profits can be manipulated to give a better-than-warranted impression of corporate progress and health, it is far harder to pull such tricks with a company's cash flow statement. Many mantras abound about the wisdom of focusing on cash, such as the old classic, "turnover is vanity, profit is sanity but cash is reality".
However, while cash, as the lifeblood of a company, does represent a vital "reality", it does not necessarily always give the best picture of a business's trajectory due to the fact that cash flows can be very lumpy. This makes cash hard to read. That means cash flow statements are often ignored by the market which tends to prefer the clearer narrative offered by the profit and loss account - even if this sometimes proves to be more fiction than fact.
It's the fact that the market so readily overlooks cash flow that, in my opinion, provides investors who are cash focused with a key advantage. Just as a company that is producing big profits but failing to convert them into cash may be not as good as suggested by an earnings-based analysis, a company generating large amounts of cash compared with its profits may be better than it looks. And highly cash-generative companies can offer all kinds of pleasant surprises, such as maintaining a dividend when times are tough, making extra returns to shareholders like special dividends, and funding investment in growth.
In my recent "7 Golden Ratios" feature, star fund manager Jeremy Lang also suggested that a strong free cash flow return (FCF) on assets (TA) can indicate that management are focused on running a business in the best interests of shareholders, as opposed to focusing on aggrandising their own egos. I'm taken with this idea and I have built his ratio (FCF/TA) into the quality test used by this year's free cash flow kings screen. The ratio also seems to complement the screens' requirement that stocks offer a high dividend yield, which provides a sign that management are not only focused on generating cash for shareholders but are also focused on paying it out to shareholders. The full screening criteria, which includes and extended quality test (the old one focused solely on return on equity), are as follows:
■ FCF higher than it was five years ago and rising in at least three of the past 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 greater or equal to 10 per cent, OR free cash flow return on assets (FCF/TA) greater or equal to the median average, OR operating margins greater or equal to the median average; ■ EV/FCF ratio below the median average; ■ A dividend yield in the top third of all dividend-paying shares. |
The FTSE All-Share has been screened separately from the FTSE All-Small and Aim indices to try to ensure a spread of both larger and smaller company results. All in all, nine stocks passed the screen's tests and I've provided write ups of the five highest-yielding shares below. The other shares that passed the screen are included in the fundamentals table. The focus on high dividend yields gives this screen a somewhat contrarian stance, especially where the highest-yielding stocks are concerned.
HIGH-YIELD FREE CASH FLOW KINGS
