Cash Magic cashes in – again

The attraction of cash is that as a measure of a company’s performance it is hard to fudge. Cash flow also represents the lifeblood of a company. Sadly, investors are rarely lacking examples that underline the importance of paying attention to cash. Perhaps the lesson most deeply seared into investors’ memories at the moment is failed construction and outsourcing company Carillion.

While cash flow statements can be manipulated and flattered though the timing of payments and purchases by a company, the scope for shenanigans is far less than with the much-scrutinised profit and loss account. The fact is, the cash flow statement records the cash that actually comes in and out of a company’s coffers during the year, which provides a relatively hard-and-fast picture of the commercial reality of a trading period.

If cash flows represent commercial reality, a profit-and-loss account is more a reflection of the commercial logic of a trading period. For example, a big expenditure on stock to meet an anticipated upturn in demand during a subsequent trading period will mean an outflow of cash, whereas the stock build will not be recorded as a cost on the profit-and-loss account until it is sold – neatly matching costs with sales despite their impact on cash flows occurring in different trading periods. Cash flows should ultimately match, but the story told by the cash flow statement will be lumpier and less easy to make sense of.

The nasty surprise comes for profit-and-loss-focused investors if the commercial decision to increase stock levels was a bad one. Should management be forced to cut prices to clear its warehouses this will result in writedowns and an accompanying earnings hit – possibly even lower cash inflows from the sale of stock than the outflows at the time of its original purchase. For earning sceptics, another worrying dimension to such a situation is the pressure management may feel to put off the day of reckoning for the profit-and-loss account by simply holding overvalued stock on the balance sheet. While cash flows will reflect the poor stock purchase decision, it will remain hidden from investors focused on the profit-and-loss account until the group is finally forced to fess up.

However, the flipside to the warts-and-all honesty of the cash flow statement is that numbers can fluctuate a lot due to the lumpy nature of much investment (for example, building a large expensive factory with a 25-year life). In theory, good accounting should mean the profit-and-loss presents an easier-to-read picture of a trading that marries with the cash flow statement over time. However, as no one knows how the future will pan out and what returns will be on investments until those returns are made, the reality of cash provides an important guide.

The Cash Magic screen takes inspiration from the “magic formula” invented by hedge fund manager Joel Greenblatt. However, rather than using a ranking based on an earnings-based valuation and quality measure, the Cash Magic screen uses similar cash-based valuation and quality measures – the details of which can be found below. For his magic formula, Mr Greenblatt recommends constructing an annually reshuffled portfolio of stocks based on the top 30 ranking shares. The cash magic screen constructs a 30-stock portfolio on a similar basis. I’ve also been running an experiment to see if results are improved by focusing on stocks showing positive earnings momentum.

So far the version of the screen that uses momentum as an additional guide has fared worse than the top 30 stock version. Indeed, last year three of the screen’s top-performing picks were excluded from the momentum version of the screen because their shares had performed poorly in the preceding three months. Overall the top 30 cash magic portfolio produced a 19.5 per cent total return last year compared with 8.9 per cent from the FTSE All-Share index, which is the index the screen is conducted on. The momentum version of the screen produced a 7.6 per cent total return, which is the first time in the five years I have run the screen that either of its versions has underperformed the market. While I can’t say when the year-on-year outperformance record of this screen will end, it's important to note that the fact of it ending at some point is sadly inevitable. Indeed, in Mr Greenblatt’s classic book The Little Book That Beats The Market in which he set out his magic formula, he suggested the screen was only really of value to people who could persist with it during bouts of underperformance.

Cash Magic top 30 2017 performance

Momentum Cash Magic

Source: Thomson Datastream

The cumulative performance of the screen since inception looks very impressive at the moment, with the Top 30 showing a 172 per cent total return over five years, or 130 per cent if I factor in a 1.5 per cent annual dealing charge, compared with 50.3 per cent from the FTSE All-Share. Meanwhile, the momentum version of the screen boasts a 127 per cent five-year return or 110 per cent with notional costs.

The screen works by separately ranking all stocks for value and for quality. A combined ranking is then created from which the most attractive 30 shares are picked. For the momentum version of the screen, all shares that display better than median average three-month share price performance and are ranked among the top fifth are selected.

The quality measure the Cash Magic screen uses is cash return on capital invested (CROCI). This ratio tells us how much free cash a company has generated as a proportion of the capital used in its operations. CROCI is like a cash equivalent of the more widely used return on capital employed (ROCE). It is calculated as: Free cash flow (adjusted for cash finance costs/income)/capital employed.

The value metric the screen uses is the enterprise value to free cash flow (EV/FCF) ratio. EV/FCF is a cash flow equivalent to a price/earnings ratio, adjusted to factor in the amount of net cash or debt a company holds. The top 30 shares can be found in the table below followed by the results for the momentum version of the screen.

Cash Magic top 30 2018

Momentum Cash Magic

Source: S&P CapitalIQ