Why our 'Cash Magic' screen is doubling down on oil

Some might view this focus on cash as conservative, or even cynical. That’s because by looking beyond reported or adjusted profits, the screens in effect raise an eyebrow at the accounting numbers that executives are most fond of highlighting.

This isn’t to say that earnings figures don’t matter, or that there aren’t legitimate reasons to pay more attention to the income statement than the cash flow statement. Investors must make peace with the fact that management teams have options in deciding when to recognise revenue and income, and balancing profits against working capital needs.

Free cash flows, by comparison, can be lumpy. But because it is the lifeblood of a business, cash really does matter to investors. This may be particularly true when it is more difficult to both source and make. Today’s tougher financing conditions, alongside all manner of economic and industry risks, mean these two tests are tougher to pass than they have been for much of the post-2008 period.

Since the end of 2021, one could even make the argument that those companies with the strongest cash generation profiles should be leading equity markets.

The evidence for this, however, is a little more mixed. Since we introduced it a little over a year ago, a US version of the screen is nicely ahead of the S&P 500. While this suggests investors have started to take a bit more of a critical view of cash generation in recent months, it’s still too early to read much into this performance.

What is apparent, however, is that the original UK screen has had less of a strong run of late. Now a decade old, it was for the first eight years of its life an excellent performer. But for the past two years it has failed to maintain its momentum, and has instead stuttered in both absolute and relative terms.

In the 51 weeks to 24 May 2023, last year’s cohort made a 12 per cent total loss, compared with a 2.6 per cent positive return from the benchmark, the FTSE All-Share.

Since we started following this screen in 2013, its top 30 stocks version has racked up a cumulative total return of 160 per cent. A version that incorporates market momentum (see more below) has returned 107 per cent. Both compare favourably – if much less so than at their 2021 peak – with an 83 per cent return from the FTSE All-Share. 

While the screens are meant as ideas for further research rather than off-the-shelf portfolios, a hypothetical 1.5 per cent annual charge would reduce the all-time total return for the top 30 screen to 124 per cent, and 78 per cent for the momentum version. The alpha the screens once possessed has steadily leached away.

Where, then, has the magic gone? Last year, I allotted some of the blame to a tweak made to the screen in 2021. Historically, it had looked at an FCF valuation measure based on a standardised treatment of historical numbers. But for reasons of data quality – and what has proved to be unwarranted optimism in the predictive powers of analysts – we switched from reported to forecast figures.

FCF is a tricky number to forecast. Although it is harder to manipulate than earnings per share, the ability to gauge it with accuracy relies on having a good handle not only on a company's income statement, but working capital movements, one-off charges and the broader management of cash in the business. Some analysts forgo the exercise entirely.

Because there’s less wriggle room to ‘adjust’ FCF, it can lead to complications when analysing standalone financial statements. That appears to have been the case with the screen’s number one pick from 2022, 888 Holdings (888), which turned out to be its worst performer. For the second consecutive year, what appeared to be a free cash generation windfall from the integration of William Hill has proved a mirage, as the UK-focused gambling group has stumbled on compliance issues, fears about slower sector growth, and the rising cost of debt.

Although I’ve again stuck with the forecast FCF methodology this year, I will admit to feeling a little concerned that our 2023 picks could again suffer from the sugar rush of a near-term cash generation boom.

Indeed, no fewer than eight of the top 10 stocks in the main version of the Cash Magic screen are involved in oil and gas, where prices, profits and FCF are always hard to call. The top two – sentiment-sapped North Sea independents Harbour Energy (HBR) and EnQuest (ENQ) – feel like especially high-risk bets just a week after Labour leader Keir Starmer pledged to block all new oil and gas developments in the UK if he is elected at the next general election. This is an inauspicious moment to back the future of the UK Continental Shelf, even if there is a lot of cash to be made in the coming months.