Hunting cash magic kings

Performance 2018

Source: Thomson Datastream

This screen takes its cue from the Magic Formula screen devised by hedge fund star Joe Greenblatt and set out in his bestseller, The Little Book That Beats The Market. Mr Greenblatt’s screen focuses on the two key investment questions: what is the quality of a company and how much are investors being asked to pay it. The screen uses a ranking system to play off the value on offer against quality. My Cash Magic screen replaces Mr Greenblatt’s earnings-based value and quality metrics with similar metrics based on free cash flow (FCF). FCF reflects the cash available to the company after all necessary spending during the year has been accounted for. Sometimes FCF is calculated based only on an estimate of investment required to maintain operations, but the calculation used by this screen takes into account all investment spending whether it be for growth or maintenance.

Looking at cash instead of earnings has both advantages and disadvantages. The main plus that cash fans point to is that a cash flow statement is trickier to fudge than an earnings statement. Meanwhile, cash-draining movements in working capital can provide valuable early warning signs of trouble to come: a recent example being the build-up in second-hand car stock at motor dealer Pendragon ahead of a devastating profit warning this month.

Putting more emphasis on cash to spot problems early and circumvent accounting trickery is not a bad premise, but it cannot protect investors against an outright fraud. However, it is worth being aware that there are still plenty of tricks that crafty finance chiefs can pull to flatter cash flow. Aggressive collection of payments on outstanding invoices and withholding payments of bills to coincide with accounting period ends is commonplace and can give an overly flattering view of cash.

Financial sleight of hand can also be used to move cash items between the three sections of the cash flow statement (‘operating’, ‘investing’ and ‘financing’). The aim here is normally to inflate operating cash flow, which investors tend to pay most attention to. This screen looks at FCF rather than operating cash flow, which means it dodges some of these tricks. But because the screen looks at so-called FCF-to-firm, which ignores interest expenses, it is still susceptible to certain types of trickery that attempt to present operating cash items as financing items. Overall, though, cash certainly tends to be a measure of financial performance that is more grounded in the financial realities of a company’s year.

But herein lies a problem for cash-focused investors. Sometimes the financial reality of a year does little to reflect the real long-term significance of financial decisions. This is especially true when there are large investment-related outflows, which helps explain why so much attention is often placed on operating cash (cash generated before investing) despite it being the most susceptible to manipulation. Take, for example, a company that spends a large sum on a factory that is expected to have a useful life of 25 years. While the cash performance in the years the factory is being built will look terrible, the real costs to shareholders are arguably better reflected in the depreciation that will be reported in the profit-and-loss statement to spread the cost out over the factory’s life. The erratic nature of companies’ investments mean FCF can be particularly lumpy and may give a confused picture. In fact, given the lumpiness of FCF, I’m quite surprised this screen has had such a consistent run up until last year’s annus horribilis.

Following last year’s poor performance, the version of the screen based on the 30 top ranking shares (more details above) boasts a cumulative total return over six years of 131 per cent, while the momentum version of the screen boasts 124 per cent. This compares with a 46.1 per cent total return for the FTSE All-Share, which is the index stocks are selected from. If I factor in a 1.5 per cent annual charge to reflect real world dealing costs the total return from the top 30 screen drops to 111 per cent and 105 per cent for the momentum screen.

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 of shares 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 above. The results for the momentum version of the screen can be seen on our website.

The screen results from this year can be seen in the table above along with some relevant fundamentals.

Cash magic top 30

Momentum cash magic

Source: S&P Capital IQ

*All foreign FX converted to £