13 high yielding cash flow kings

The problem with cash flow is that it is often just a bit too 'real' to be an easy mainstay of company analysis. There are many perfectly sensible management actions that can hit cash flow in any single year, such as providing credit to customers to secure high-value orders; the purchase of stock ahead of an expected uptick in demand; or making a large one-off investment that will reap returns over may years, are all potentially sensible actions that can hit cash flow. The profit and loss attempts to smooth things out so cash being used can be seen in context of the benefits (real, expected or imagined) to a company.

However, whenever cash is committed to business activities, even when sensibly intentioned, it nevertheless represents a risk: high-value orders on credit are only good if bills are eventually paid; increasing stock can be ruinous if anticipated demand does not materialise; and big investments can be financially disastrous if returns are lower than expected. More importantly, persistent cash-flow trends can offer significant clues to the real health of a business.

The fact that judgements about cash flows are often nuanced can make cash-focused analysis tricky and confusing compared with the more easily digestible but easier-to-manipulate picture provided by earnings. Often the cash-flow statement is used by investors to prompt questions about how a business is being run rather than providing answers.

The fact that cash flows are often a secondary consideration provides an interesting gap in the market for cash-centric investors. A company with strong cash conversion may have a higher-quality business than the earnings-obsessed market gives it credit for, which provides the opportunity to find undervalued shares.

That’s all good in theory, but my Free Cash Flow (FCF) Kings stock screen has yet to put in a performance that does much credit to the ideas behind targeting cash flow. Personally, I don’t currently see this as a major problem. Some approaches can be expected to produce poor returns for relatively long stretches while still being valid. Indeed, given this screen has a focus on dividend yield, its soggy performance tallies with the relatively poor returns of many UK income-focused funds, even those run by star managers such as Neil Woodford.

Last year the 15 stocks selected by the screen generated a negative total return of 2.8 per cent compared with a positive 2.3 per cent from the FTSE All-Share. The cumulative total return from the screen since I began monitoring it five years ago stands at 45 per cent, dropping to 35 per cent once I factor in a notional annual charge of 1.5 per cent for switching portfolios each year (the assumption of this column is that the screens are primarily of use to readers as a source of idea generation rather than off-the-shelf portfolios). After applying the annual charge, the return from the screen is below that of the FTSE All-Share over the same period at 37 per cent.

2017 performance

The screen’s full criteria are as follows:

■ FCF higher than it was five years ago and rising in at least three of the past five years.

■ Operating cash conversion (cash from operations/operating profit x 100) of over 100 per cent in at least two of the past three years.

■ Net debt less than two times cash profits (Ebitda).

■ FCF return on total assets (FCF/TA) greater or equal to the median average.

■ A pension-deficit-adjusted enterprise value (EV)/FCF ratio among the cheapest quarter of all stocks screened (below 16.9 times).

■ A dividend yield (DY) in the top third of all dividend-paying shares screened.

I have ordered the 13 stocks highlighted by the screen from lowest to highest forecast price/earnings (PE) ratio. Given the view that cash gives investors a different perspective on reported earnings, I have also provided a write-up of the stock with the lowest and the highest PE ratios in the table to give a flavour of the results.

Source: S&P Capital IQ

Communisis

A key attraction of buying a company that looks cheap compared with its cash generation is that that the market may be underestimating the quality of its earnings. If this proves to be the case, the shares have the potential to re-rate against earnings. In the case of Communisis, which is the cheapest of all stocks passing the FCF Kings screen based on its next-12-month forecast PE ratio, a change in sentiment has the potential for a substantial rerating.

That said, it may take some time and a fair bit of progress for the mood to change. A long shadow hangs over the company due to its roots in print media (direct mail and display stands). But while recent share price performance and a chequered history provides grounds for scepticism, for those that dare to hope there are several factors that could move in the company’s favour in the coming years.

Communisis has two divisions. Its customer experience business mainly does work for financial services companies to handle client communications, which are often highly regulated. The business can be regarded as being in a far stronger competitive position than more general direct-mail marketing companies because regulation makes the work complex and "mission critical", while its contracts tend to be big and stretch out over several years. Indeed, double-digit operating margins attest to this – although these margins are taken before accounting for corporate and central costs that absorbed about 45 per cent of divisional profit last year. Customer experience accounted for 50 per cent of sales last year and 58 per cent of profit. Communisis’s other division designs and places point-of-sale marketing material for large, international fast-moving consumer goods brands.

A major theme for the company is a move by its customer-experience clients from print-based communication (letters) to digital communication (email). This shift in the make-up of work (14 per cent of first-half revenue was digital compared with 9 per cent over the same six months a year earlier) is reducing the amount of day-to-day capital tied up in servicing clients, which in turn is boosting cash generation. The reduction in the costs associated with printing and posting letters is also increasing the division’s margins, although some of this is being offset by falling revenues.

Communisis is hoping to make the most of these changes while making its operations more efficient through its Value Enhancement Programme (VEP). Over three years from early 2018 the programme will aim to increase Communisis’s focus on digital work, overseas revenue growth and creating deeper client relationships. In terms of specifics, this has meant investing more in technology, both to improve the services currently offered and to push the business into exciting areas such as fraud prevention and data analytics.

A £2.9m uptick in spending on technology saw first-half free cash flow fall from £6.5m to £5.5m, although net operating cash flow rose from £7.5m to £8.4m. The company is also trying to foster more entrepreneurship with local managers by devolving both decision-making and central costs to make individual business units more accountable for returns.

For shareholders, a key metric by which the success of VEP is to be measured is the company’s target to achieve a three-year compound annual EPS growth rate of 5 to 10 per cent. As suggested by a recent share price drop, the jury remains out on whether the target is achievable, especially as the introduction of General Data Protection Regulation (GDPR) led to a slump in direct mail business during the first six months of the year. Nevertheless, management thinks full-year expectations will be met based on recent contract wins and the revenue visibility provided by its large, long-term contracts. What’s more, the company has argued that GDPR regulation should bolster its competitive position in the longer term by deterring smaller players.

While trading in the first half may have caused some worry, there was more comfort to be taken from improvements to group finances. Net debt fell 16 per cent to £23.7m in the first half and falling pension liabilities meant the group’s defined-benefit pension scheme deficit dropped to £32m from £42m a year earlier. The company was also confident enough in prospects to increase the half-year dividend by 5 per cent.

The market seems to be pricing in the risk of further disappointment from Communisis far more than the chance it will actually achieve its goals. Based on Bloomberg data, the current forward PE ratio is in the bottom fifth of the five-year range and offers about 20 per cent rerating upside were it to get back to the five-year average. While scepticism is understandable, the perception of the company should be helped by the improving financial position and the cash flow tailwind supplied by the digital switch.

Ashmore

If Communisis is a company that appears that appears to be priced for the worse, then the valuation of shares in specialist emerging market fund manager Ashmore looks like a counter case. Emerging markets have had a torrid 2018 so far as the combination of a strengthening dollar and burgeoning trade war have taken their toll.

Despite this, Ashmore has not fared too badly. True, the shares are 14 per cent below their early 2018 high, but the valuation does not look low compared with history. What’s more, when the company reported full-year results to the end of June, not only was it able to point to net inflows of $16.9bn during the year, taking the total to $73.9bn, but it also reported solid inflows for July and August. That said, July and August are quiet months for the business and first-quarter results on 12 October are likely to be watched closely.

A key reason for Ashmore’s resilience in the face of turbulent emerging markets performance is likely to be its focus on institutional clients. Institutions are regarded as taking a longer-term view on their investments, which makes them happier to ride out periods of volatility. However, should weakness in emerging markets persist, negative trends could start to impact fund flows. Broker Numis says it would expect fund flows to turn in earnest in 2019 if emerging markets remain difficult.

There are reasons to hope conditions will improve before then. Ashmore argues that most of the issues being faced by emerging markets are less to do with fundamentals and more about events in developed markets. What’s more, Ashmore itself has a history of producing outperformance from its investments following periods of turbulence.

There is the clear risk, though, that investors will get scared off, and if assets under management begin to fall, the company’s relatively fixed cost base will mean lower fees are likely to hit the bottom line hard. The shares' current rating suggests the negative scenario could result in a serious de-rating with the current forecast yield of 4.5 per cent sitting in the top fifth of the five-year range and some way below the five-year average of 5.2 per cent and well shy of the five-year high of 8.5 per cent.