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Thirty cash magic stocks

Accounting changes risk making cash flows more confusing
Thirty cash magic stocks

Something investors tend to love about cash is that it is so tangible. You know what you’re getting with cash… don’t you? 

The truth is that while numbers from the cash flow statement are generally less malleable than those from the income statement, they can still be fudged and faked. But more pertinently from the perspective of this week’s screen, cash flow statements need to be interpreted on the basis of prevailing accounting rules. The reason this is very pertinent at the moment is that an accounting rule has recently been brought in that could cause confusion to investors that don’t pay it due consideration when looking at cash flow. 

The rule in question concerns how a company accounts for its rented assets and future rent commitments - so-called 'right-of-use assets' and associated 'lease liabilities'. 

The new rule should generally be regarded as very positive for investors. A company’s agreement to rent operating assets such as property or vehicles are best regarded by shareholders as a form of borrowing. This is because the liabilities associated with leases need to be paid before shareholders can get their cut of profit. Historically these liabilities were not reported on the balance sheet, though. Instead, investors had to root through the notes to a company’s accounts in order to find out how much rent was included within reported costs before making an estimate about the size of the longer-term liability associated with rental contracts. 

But companies reporting on financial years that started after 2018 are now required to report rental assets and liabilities on the balance sheet. That means most companies have now issued a set of accounts incorporating the new standards or are close to doing so.

The issue for interpreting cash flow is the result of how companies now report their rent paid during the year. To make sense of the new items on the balance sheet, companies now have to break down rent into an interest charge associated with the notional 'financing' provided by the asset owner and also a 'depreciation' charge related to their use of the asset in the period reported on. 

The accounting logic behind this is less important than simply understanding that the cash flow statement treats depreciation as a non-cash charge. This means the new accounting treatment boosts cash flow if no adjustment is made for the change. This is especially true for companies that lease a lot of assets, which will suddenly look a lot more cash generative without any adjustment.  

The primary focus of this week’s screen is free cash flow (FCF). FCF is meant to represent cash generated by a company to do things like pay down debt, make acquisitions, or pay dividends. This means it takes account of amounts invested in a business during the year (known as capital expenditure or CAPEX). So that the cash expense of CAPEX can be spread out over the investment’s useful economic life an annual depreciation charge is applied to the income statement. As depreciation is a non-cash charge, it is traditionally ignored when calculating cash flow..

The rental depreciation charge is a bit different because it largely does relate to cash payments in the period. At the moment, it seems that many standard calculations of FCF are ignoring this issue and it is very much worth checking with data providers how the number is being calculated. 

Fortunately, for investors in the know there is an easy way to adjust for the accounting change. In the third and final section of the cash flow statement dealing with 'financing' – a section that traditionally has largely been ignored for FCF calculations – companies now report an item for lease repayments. This can be subtracted from FCF to offset the effect of the lease depreciation charge. Simply factoring this number into FCF provides a good fix.

There is debate among finance wonks over whether there is a better way. Some think it is best to treat new rental agreements in the same way one would treat capital expenditure. To do this, the method of adjusting FCF is to ignore the lease repayment figure and instead subtract the change in a company’s right-of-use assets. The idea here is that the increase in the value of right-of-use assets is the same as Capex. 

There is a third way to make the necessary adjustment, too. This is illustrated in Philip Ryland’s Accounting that Counts feature this week – the crossover between my column and his feature is entirely unplanned but by chance we have even used the same company to illustrate our points (see below)! The adjustment method used by him is to add back the depreciation charge related to leases to cash flows. 

The fact that all three adjustments (either subtracting capital lease payments, subtracting growth in right-of-use assets or adding back depreciation) can be considered valid, but all give different cash flow numbers, shows just how important interpretation is when calculating something that’s apparently as solid as cash.

 

An example

An example may be helpful to explain the above. Let’s take the case of retailer Next, which is a company that rents a lot of store space. In its financial year to the end of January 2019, before the new rules came into effect, it included £225m of rent within its operating expenses. The impact on cash was reflected in the first of the three sections of the cash flow statement, which deals with operating items. 

Following the introduction of the new rule, overall cash cost associated with its lease payments was largely unchanged at £234m in total. However, only £10m of this was accounted for by rent payments. The rest was made up of a £62m interest charge associated with its lease liabilities and a £163m capital lease repayment charge. Failing to adjust for the capital lease repayment would have substantially flattered the FCF figure simply by virtue of the company using lots of leases (see table).

 

Next (NXT)
Yr to end Jan20202019
THE OLD WAYS
Depreciation old method£125m£122m
CF Lease Exp/Rent£234m£225m
WHAT'S CHANGED
Rent expense£10m£225m
Capital lease repayment£163m-
Lease interest£62m-
Lease depreciation£138m-
FCF ADJUSTMENT
FCF old method£688m£489m
FCF less lease repayments£525m£489m

Source: FactSet

 

Adjusted and ready to go

My cash magic screen is making the adjustment for lease repayments in all cases where accounts filed under the new rules are available. Importantly this FCF number is broadly comparable with the method used to calculate FCF for companies yet to publish accounts under the new regime.

As for the screen itself, it looks for two things: firstly how cheap a company looks compared with its FCF based on its enterprise value (EV)/FCF ratio; and secondly the quality of a company’s operations based on FCF as a proportion of money invested in the business (capital employed). The quality measure is known as cash return on capital invested (CROCI). All FTSE All Share members are ranked separately for EV/FCF and CROCI and then a final ranking is compiled based on the combined rankings. 

The screen is devised as a cash-centric version of the “magic formula” invented by hedge-fund legend Joel Greenblatt who set out the magic formula in his classic The Little Book That Beats The Market. As well as a screen based on the Top 30 ranking shares, I run a screen every year based on shares ranked in the top fifth showing momentum that is better than the FTSE All Share index.

 

2019 performance 

CASH MAGIC
TOP 30WITH MOMENTUM
Name TIDMTotal Return (18 Jun 20190 - 22 Jun 2020)Name TIDMTotal Return (18 Jun 20190 - 22 Jun 2020)
GALLIFORD TRYGFRD103%AVASTavst67%
COBHAMCOB55%CENTAMINcey64%
ENTERTAINMENT ONE (DI)ETO43%ASHTEAD GROUPAHT34%
ASHTEAD GROUPAHT34%GVC HOLDINGSGVC27%
GVC HOLDINGSGVC27%OXFORD INSTRUMENTSoxig22%
BERKELEY GROUP HDG.BKG25%MOTORPOINT GROUPMOTR19%
HANSTEEN HOLDINGSHSTN23%FERGUSONferg19%
MOTORPOINT GROUPMOTR19%REACHrch15%
RANK GROUPRNK8.5%GOCO GROUPgoco12%
SAINSBURY JSBRY2.5%SPEEDY HIRESDY0.7%
SPEEDY HIRESDY0.7%TARSUS GROUP DEAD - DELIST.14/08/19trs-0.9%
BARRATT DEVELOPMENTSBDEV-4.2%UNILEVER (UK)ulvr-4.1%
LSL PROPERTY SERVICESLSL-4.6%TALKTALK TELECOM GROUPTALK-18%
DRAX GROUPDRX-15%ENQUESTenq-21%
TALKTALK TELECOM GROUPTALK-18%NORCROSnxr-22%
MCBRIDEMCB-20%STD.LF.INV.PR.INC.TST.sli-24%
PLAYTECHPTEC-23%WINCANTONWIN-26%
WINCANTONWIN-26%DFS FURNITUREdfs-28%
EUROMONEY INSTL.INVESTORERM-29%PAYPOINTpay-29%
NORTHGATENTG-34%ROBERT WALTERSRWA-39%
STV GROUPSTVG-34%ENERGEANenog-41%
ROBERT WALTERSRWA-39%MITIE GROUPMTO-50%
MCCOLL'S RETAIL GP.MCLS-40%EVRAZEVR-51%
MITIE GROUPMTO-50%HOSTELWORLD GROUPHSW-59%
PETROFACPFC-50%MACAU PR.OPPOR.FUNDMPO-62%
MARKS & SPENCER GROUPMKS-50%---
EVRAZEVR-51%---
HOSTELWORLD GROUPHSW-59%---
GEM DIAMONDS (DI)GEMD-61%---
MACAU PR.OPPOR.FUNDMPO-62%---
FTSE All Share--11%FTSE All Share--11%
Cash Magic--11%Mom Cash--7.8%

Source: Thomson Datastream

 

While the screen is very simple, the results from it have been pretty impressive since I started running it in 2013. Both the version of the screen based on the top 30 and the screen factoring in momentum have delivered a similar total return although the momentum version has provided a much smoother ride. The cumulative total return from the top 30 is 106 per cent compared with 31 per cent from the FTSE All Share. The momentum version has returned 108 per cent over the seven years. While the screens in this column are presented primarily as a source of ideas for further research, if I factor in a notional 1.5 per cent annual charge to represent dealing costs the total return drops to 86 per cent and 87 per cent for the respective screens. 

 

 

The results from both this year’s screens can be found in the tables below.

 

Top 30

NameTIDMSectorMkt CapPriceFwd NTM PEDYEV/FCFCROCIEPS grth FY+1EPS grth FY+23-mth MomentumNet Cash/Debt(-)Rank
Ninety One PlcN91Asset Management and Financial Advisory Services£1,364m219p16-2.3316%-21%12%-£165m1
Rolls-Royce Holdings plcRRAerospace Equipment£6,453m334p821.4%5.462%---46%-£1,236m3
Evraz PLCEVRPrimary Metals Products£4,295m295p820.3%4.631%89%18%-10%-$2,522m4
EnQuest PLCENQOther Fossil Fuel Exploration and Production£266m16p-0.0%3.723%---21%-$1,599m5
Go-Ahead Group plcGOGOther Passenger Transportation£432m1,000p910.2%3.022%-48%32%-49%-£419m5
Beazley PlcBEZProperty and Casualty Insurance£2,609m429p242.9%5.826%-90%984%-20%-$232m8
Premier Oil plcPMOOther Fossil Fuel Exploration and Production£462m50p-0.0%3.921%---35%-$2,041m9
Tullow Oil plcTLWOther Fossil Fuel Exploration and Production£476m34p-16.6%4.321%--0%-$3,176m10
Jupiter Fund Management plcJUPAsset Management and Financial Advisory Services£1,108m242p137.1%5.422%-34%1%-19%£318m11
Vivo Energy PlcVVOGasoline Stations£1,114m88p111.0%5.422%-36%66%-12%-$157m12
Apax Global Alpha Ltd.APAXInvestment Managers£670m136p-7.0%3.918%---8%€3m13
Vistry Group PLCVTYHome Builders£1,694m778p87.6%3.318%-22%29%-39%£339m14
Robert Walters PlcRWAAdministrative Services£304m400p263.9%5.719%-84%222%-27%£10m16
Connect Group PLCCNCTEntertainment Retail£37m15p26.7%8.436%-13%22%-45%-£90m17
PayPoint plcPAYConsumer Finance Services£480m702p136.0%9.644%-19%13%-15%£23m19
Stagecoach Group plcSGCOther Passenger Transportation£368m67p2011.5%7.020%-47%-81%-49%-£394m20
ITV PLCITVEntertainment and Programming Providers£3,149m78p83.3%8.325%-38%26%-33%-£869m21
Photo-Me International plcPHTMPersonal Services£209m55p715.2%5.916%-5%6%-34%£8m22
SThree plcSTEMAdministrative Services£365m275p161.9%9.631%-56%41%-13%£11m22
888 Holdings Plc888Arts, Entertainment and Recreation Providers£568m154p153.2%10.032%-11%17%35%$35m24
Keller Group plcKLRInfrastructure Construction/Contracting Services£514m713p105.0%6.416%-25%32%10%-£290m26
Norcros plcNXRArchitectural and Infrastructure Component Makers£132m164p105.3%6.015%-47%78%-23%-£71m27
Schroders PLCSDRAsset Management and Financial Advisory Services£8,018m2,990p183.8%8.218%-19%5%5%£2,138m29
Halfords Group PlcHFDMotor Vehicles and Parts Sales and Rental£336m169p1711.0%6.215%-9%-68%12%-£450m29
Reach plcRCHPrint Media and Publishing Services£257m86p37.6%2.913%-30%13%-41%£20m31
DP Eurasia NVDPEURestaurants and Bars£56m38p-0.0%8.117%---33%-TRY64m32
Balfour Beatty plcBBYInfrastructure Construction/Contracting Services£1,879m272p150.8%6.114%-51%91%11%-£20m34
Rathbone Brothers PlcRATAsset Management and Financial Advisory Services£791m1,400p155.0%-15.612%-30%4%-16%£1,852m34
Ferrexpo plcFXPOBase Metal Mining£1,052m179p65.9%6.515%-46%-25%38%-$212m36
Aggreko plcAGKEquipment and Supplies Distributors£1,269m495p131.9%6.314%-39%54%-27%-£584m36

Source: FactSet

With momentum

NameTIDMSectorMkt CapPriceFwd NTM PEDYEV/FCFCROCIEPS grth FY+1EPS grth FY+23-mth MomentumNet Cash/Debt(-)CurRank
Ninety One PlcN91Asset Management and Financial Advisory Services£1,364m219p16-2316%-21%12%-£165mGBP1
Tullow Oil plcTLWOther Fossil Fuel Exploration and Production£476m34p-16.6%421%--0%-$3,176mUSD10
888 Holdings Plc888Arts, Entertainment and Recreation Providers£568m154p153.2%1032%-11%17%35%$35mUSD24
Keller Group plcKLRInfrastructure Construction/Contracting Services£514m713p105.0%616%-25%32%10%-£290mGBP26
Schroders PLCSDRAsset Management and Financial Advisory Services£8,018m2,990p183.8%818%-19%5%5%£2,138mGBP29
Halfords Group PlcHFDMotor Vehicles and Parts Sales and Rental£336m169p1711.0%615%-9%-68%12%-£450mGBP29
Balfour Beatty plcBBYInfrastructure Construction/Contracting Services£1,879m272p150.8%614%-51%91%11%-£20mGBP34
Ferrexpo plcFXPOBase Metal Mining£1,052m179p65.9%715%-46%-25%38%-$212mUSD36
Hastings Group Holdings PlcHSTGProperty and Casualty Insurance£1,243m188p125.3%818%46%8%15%-£95mGBP38
Plus500 Ltd.PLUSSecurities Sales and Trading Services£1,306m1,226p74.2%1245%95%-40%29%$217mUSD39
Hochschild Mining plcHOCPrecious Metal Mining£1,027m200p220.8%917%22%130%25%-$25mUSD46
Rio Tinto plcRIOBase Metal Mining£55,690m4,467p116.7%1019%-15%-13%24%-$2,624mUSD50
Playtech plcPTECArts, Entertainment and Recreation Providers£933m312p135.3%512%-53%79%25%-€301mEUR51
BHP Group PlcBHPBase Metal Mining£34,072m1,613p137.0%1017%2%-17%14%-$9,418mUSD57
Devro plcDVOFood Production£294m176p111.5%1117%2%10%18%-£125mGBP67
IG Group Holdings plcIGGSecurities Sales and Trading Services£2,994m810p165.3%1321%47%-21%20%£357mGBP72
CMC Markets PlcCMCXSecurities Sales and Trading Services£794m275p135.5%1318%-22%-27%83%£89mGBP72
ContourGlobal PlcGLOOther International Wholesale Power£1,271m190p206.4%913%-9%31%9%-$2,691mUSD75
Moneysupermarket.com Group plcMONYConsumer Data and Services£1,798m335p193.5%1747%-12%16%8%-£10mGBP85

Source: FactSet