Cash in with these Cash Magic shares

Free cash flow (FCF) has always been a vital number for investors to pay attention to, but it is becoming incrementally even more important. That’s because dubious accounting standards coupled with the corporate world’s increased focus on intangible investments have made earnings numbers ever more questionable. I won’t harp on about reasons why here, but for those interested my “Finding Hidden Value” feature from 25 February provides a fulsome explanation. 

Given the genuine accounting problems that exist when reporting earnings, companies have increasingly relied on reporting adjusted earnings numbers. But this creates issues all of its own, most notably that the adjustments companies use all too often paint their profits in an extremely favourable light.

FCF can cut through all this. It tells investors what is being earned in cash terms after all the year’s necessary expenses, from capital expenditure through to tax.  

But while this sounds straightforward enough in principle, in practice FCF is a slippery customer.  It has to be well understood to be calculated and correctly interpreted in sensible ways. What’s more, what is a sensible calculation for one company’s FCF will not always be sensible for another.

There are a few major issues when calculating FCF. Firstly, there is the question of lease liabilities. It is important to include lease payments in FCF. The improved reporting of companies lease obligations on the balance sheet has created confusion in the income and cash flow statements. Whereas we used to have rent included as an operating cost, payments associated with leases (split into a notional interest payment and a repayment of the lease obligation) now appear in counter-intuitive places. In the case of cash flows, rent is found in the third section of the statement as a financing charge. Traditionally, this section of the cash flow statement is largely ignored in conventional FCF calculations. This is a particular issue for companies in the retail, leisure and transport sectors, which tend to rent a lot of their operating assets

Another second and growing issue is companies’ every increasing enthusiasm for paying their staff in shares. Issuing shares to staff is a non-cash cost, but it has cash-consequences for shareholders because it dilutes the FCF per share (the same is true for EPS). Factoring this into FCF calculations is becoming an ever more important issue. This is especially true for high-tech companies which are big users of such schemes.

Thirdly, there is the perennial issue with FCF which is that it is lumpy and also is depressed by companies spending heavily on growth. A good way to deal with this issue is to try to separate out a company’s investment in maintaining existing operations from spending on growth. Then growth spending can be excluded from a FCF calculation. Trying to put a sensible number on growth spending is hard enough for disclosed capital expenditure, but it also runs up against run up against problems associated most intangibles investment being treated as day-to-day expenses in accounts. This means it is hard to identify all capital expenditure (tangible and intangible) in the first place, even before tackling the issue of what is for growth and what is for maintenance.  

So FCF is not an easy number. This is a problem for a stock screen. Screens have to rely on standardised data and are not nuanced about how it is interpreted. This year I am altering the valuation data relied on by my cash magic screen. Historically the screen looked at a FCF valuation measure based on a standardised treatment of historical numbers. This year I am using forecast numbers instead.

The idea is that the analysts whose consensus numbers these figures are based on should have made some of the intelligent judgements to create a more sensible FCF number. Many of the issues are likely to remain, such as those associated with lumpiness and share-based payments. However, forecast numbers should provide the screen with a slightly more rounded viewpoint. 

The old method of calculating FCF did not do the Cash Magic screens too much harm last year though (see table). The version of the screen based on the Top 30 Magic Stocks delivered a 59 per cent total return from 23 June last year compared with 17 per cent from the FTSE All-Share. The version of the screen that factors in momentum returned 49 per cent. 

2020 CASH MAGIC PERFORMANCE

Since I started following this screen eight years ago, the cumulative total return for the top-30 stock version of the screen is 227 per cent and 212 per cent for a version of the screen that combines Cash Magic and momentum. The FTSE All Share has returned 68 per cent over the same period. 

While the screens are meant as ideas for further research rather than off-the-shelf portfolios, if I inject a sense of realism into the numbers by assuming a 1.5 per cent annual charge the total return for the top 30 screen drops to 189 per cent and 177 per cent for the momentum version.

Here’s how the screen works:

All FTSE All Share constituents are ranked by forecast next 12 month FCF yield (FCF per share as a percentage of share price). They are separately ranked by cash return on capital invested (CROCI). This measures how much FCF a company produced for every pound of capital employed. The two ranking are added together and a final ranking is created from this. 

For the ranked version of the screen, the top 30 stocks are selected. For the momentum version of the screen, any stock ranked among the top fifth of those screened is selected if it shows better than average (median average) three month momentum. 

The stocks selected by this year’s screen can be found below. Tables with far more detail on fundamentals are available to download online.

TOP 30 CASH MAGIC STOCKS

CASH MAGIC & MOMENTUM STOCKS

source: FactSet

*foreign FX converted to £

NTM = next 12 months

STM = second 12 months (i.e. 12 months starting in a year's time)