High-yielding free-cashflow kings

Indeed, the decision to invest heavily in a promising growth area, for example, which may be a big positive for a company, may result in a significant one off hit for cash generation. The profit and loss is able to give a far more proportionate view of such spending by using a depreciation charge to relate its upfront cost to future years during which the actual benefits of the investment should accrue. So if shareholders have a reliable narrator (finance director), the profit and loss account can provide a far more coherent narrative on a company's progress than the ups and downs of the cash flow statement. Unfortunately, the fact that the profit and loss statement makes easier reading often means cash flow gets overlooked and both potential warning signs and value opportunities can be missed.

My free cash flow (FCF) screen attempts to pick up on companies that have strong cash flow, solid businesses and shares that are going cheap. The performance of the screen over the two years I've run it has been pretty decent, producing a total return of 53 per cent compared with 37 per cent from the FTSE All-Share, although the screen only matched the 22 per cent return from the index over the most recent period from 5 September 2012 to 9 September this year. I am hoping with a bit of tinkering, though, that it can do better in the coming 12 months.

There are three key changes I am making to the screen. The first is to use the simplest definition of free cash flow available: cash from operations less capital expenditure. Often screens work best when the criteria are not overly complicated and testing this simplified FCF definition against more sophisticated versions suggests to me it will yield better results.

The other changes I am making are to increase the screen's focus on value. Shares now need be among the third highest yielders of all dividend paying shares on the market rather than simply better than average. I am also demanding that the shares have a higher than average free cash flow yield, calculated as free cash flow as a proportion of enterprise value (EV = market cap plus debt minus cash). Some FCF yield calculations use market cap as a reference point rather than EV. I'd judge EV as more appropriate as the measure of FCF I am using strips out interest paid and received. In addition, EV takes into account cash and debt which seems very pertinent when assessing a company on the basis of the cash it is throwing off.

Nine stocks passed the screen. They are listed in order of highest to lowest historic yield below:

Games Workshop

While earnings are expected to decline slightly this year at fantasy gaming chain Games Workshop (GAW), there are also reasons to feel positive. Indeed, improving economic conditions in the UK should provide a tailwind and trading in the US has already started to improve. Meanwhile, a drop in royalty revenues from computer game companies last year should now pick up as mobile games are launched by more smaller developers. But the company has tough comparisons with last year to beat. The 12 months to June 2013 benefited significantly from cost controls and good cash management, which resulted in record profits. So analysts are forecasting a small drop in earnings and, while the historic dividend yield is very eye-catching, the payment does fluctuate. Still, impressive cash generation and a firm focus on returns on capital coupled with potential tailwinds bode well.

*Based on consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Hold, 780p, 30 Jul 2013

Chesnara

Chesnara's (CSN) business essentially revolves around generating cash to return to shareholders. The company's main business involves buying closed life-assurance books which it then runs down. Given the nature of this operation, acquisitions are a key driver of growth. High solvency levels mean Chesnara is in a good position to continue to hunt for acquisitions while growing the bumper dividend - it rose 2.5 per cent in the first half. The company also has a Swedish division, Movestic, that writes new policies and this has been achieving good profit growth recently from a very low base. At the end of last month, the company announced a strong first six months to the year which was helped by strong investment markets that led to a fall in the cost of product guarantees.

*Based on consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Buy, 267p, 30 Aug 2013

HomeServe

Home accident insurance company HomeServe (HSV) has been under something of a cloud due to an FCA investigation into insurance mis-selling. But good trading both at home and in the UK has helped quell some of the market's nerves on this front. Management's attempt to put a number on the likely fine by making a £6m provision back in May has also helped sentiment. The UK business looks like it has stabilised, but some analysts are still waiting to be convinced by the new structure. Meanwhile, in the US, HomeServe has been winning new marketing partners. There has been significant investment in growth recently and efforts to push into new markets. The shares have also benefited from takeover speculation.

*Based on consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Hold, 250p, 21 May 2013

TalkTalk Telecom

TalkTalk (TALK) has experienced a tricky couple of years as it has transformed itself into a provider of a range of telecoms products, from internet to TV. It looks like things may now finally be coming good for the company. Indeed, in July it was able to report a second quarter of year-on-year revenue growth. What's more, the really fast growing bit of the business - TV subscriptions through the company's YouView service - has seen a pick up in sales momentum with TV customers more than doubling during its first quarter to 390,000. Churn rates are also down to 1.4 per cent which management attributes to the value-for-money credentials of its products.

*Based on consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Buy, 244p, 20 May 2013

British Sky Broadcasting

BT's aggressive move into the sports broadcasting market has weighed on British Sky Broadcasting (BSY) this year. The BT challenge showed up in the first half in the form of share price ructions, but there was little evidence of it hurting the business when the company reported full-year results in late July. It is early days, though, so risks remain. Meanwhile, BSkyB is attempting to use its strong cash flow to good effect by investing in new services which should have a rapid payback. It also continues to boost its dividend and recently announced a new £500m share buyback which should add about 2 per cent to its EPS growth.

*Based on consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Buy, 817p, 26 Jul 2013

Micro Focus International

IT systems improvement specialist Micro Focus (MCRO) is promising shareholders a cash return of over 20 per cent (167p) during the next 15 months through a combination of hearty regular dividend payments and special payouts worth 60p a share - made through a D share issue - both this November and next. This clearly illustrates the attraction of the company's strong cash flows. Against this, growth prospects are not great and Micro Focus has been struggling to make headway in the face of falling revenues for a number of years. But the pick up in activity in major Western economies, especially North America where Micro Focus does a lot of its business, means the prospect of a return to top-line growth looks better. Any such growth should complement the efficiency improvements that management have proved so adept at pushing through over recent years.

*Based on consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Buy, 793p, 29 Aug 2013

WH Smith

Stationery, books and mags retailer WH Smith (SMWH) is another company on our list that has used its strong cash flow to improve shareholder returns despite a period of falling turnover. As well as the attractive dividend payout, Smith has committed itself to £190m worth of share buybacks over the last five years, which has had the effect of reducing the number of shares in issue and thereby bumping up EPS. The company also has an impressive track record of boosting profits through cost-cutting. And the group's strong cash flows have also left it with money to invest in its promising travel division, which accounted for 54 per cent of last year's profit and has the potential to become a growth engine for the company now that the UK economy is beginning to pick up and boost passenger numbers.

*Based on consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Buy, 850p, 12 Sep 2013

Aberdeen Asset Management

Even before talk of tapering and the consequent turmoil that has engulfed emerging market equities, Aberdeen (ADN) had been making efforts to reduce its reliance on the asset class. The trouble is, such has been its success in investing in what for several years has been a very hot area, that its emerging market equity funds dominate the group's fortunes. And, while investors seemed to forget the risks associated with having so much business in one place during the good times, it may prove harder to ignore now. That said, Aberdeen is generating plenty of cash and is forecast to substantially increase its dividend this year - Numis has pencilled in a 48 per cent rise to 17p this year followed by 21p in 2014 - while increasing its cash position and potentially launching more share buybacks.

*Based on consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Buy, 380p, 19 Aug 2013

BBA Aviation

The market has become increasingly excited about the prospect of a cyclical upturn in aviation company BBA's (BBA) end markets, particularly due to its significant exposure to North America. While a recently reported trading uptick was mainly caused by cold weather causing an increase in de-icing work, it is increasingly seen as inevitable that demand will pick up in the US given the improvements in economic conditions. Profits should be very sensitive to any pick up and restructuring at the group during recent lean times should further help.

*Based on consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Hold, 297p, 8 Aug 2013