Put The Odds On Your Side With This Crucial Metric

Let’s face it, investing is all about making a call on a highly uncertain future.  Regardless of credentials, nobody knows what tomorrow, let alone five years from tomorrow is going to bring.  To be successful investors we need to figure out how to be right more often than wrong.

To help you invest better, we’d like to pass along an easy to calculate—and yet often overlooked–figure that, if you choose to use it, will help put the odds of success on your side.

The metric is Free Cash Flow.  With so much media focused on meaningless quarterly and annual earnings, this is a figure that can be overlooked by the masses.  Free cash is cash that is left in the business after the company has paid its bills, which include capital expenditures that are required to maintain the business. And this figure is critical to finding great companies to invest in.

Why so special?

Free cash gives a company options.  When free cash is being generated, management can invest for the company’s future in (hopefully!) high return growth projects, pay down debt to improve financial flexibility, or return the cash shareholders in the form of dividends and/or share buybacks.

Though the calculation is simple – just take Cash Flow from Operations and subtract Capital Expenditures – the power of free cash flow should not be underestimated. Those companies that are able to consistently generate free cash are the ones that you, as an investor, want to focus on.

Prove it

Want proof? Check out a list of the best and worst performers on the S&P/TSX Composite for 2012 (Market Cap > $1B), and you’ll get a glimpse of the advantage of focusing on just this one metric.  As you skim the tables below, you can easily see that many of the top performers in the index were solid free cash flow generators.

Conversely, as illustrated in the second table, the bottom dwellers for 2012 were not….

But what about……

To add a bit of colour to the exceptions in these tables, Nexen (TSX:NXY) was one of the top performers in 2012 even though it did not generate positive free cash flow over the prior twelve months.  The company was subject to a well-publicized takeover during the year which was the primary reason for the stock’s outperformance.  Prior to the takeover offer being made in July, Nexen’s stock was down 26% YTD.  Were it not for the takeover, Nexen and its negative free cash flow could very well have ended up amongst the year’s worst performers.

In addition, there were two lumber companies, West Fraser (TSX:WFT) and Canfor (TSX:CFP), that appeared amongst the best performers even though they had negative free cash flow.  Both companies served as proxies for investors looking to gain exposure to a recovering U.S. housing market.  Some might say that these stocks have moved ahead of the fundamentals, but if indeed the U.S. housing market is on the rebound, both are set to become a positive free cash flow generator, just as they have been in the past.

The name that is perhaps of greatest interest for further investigation is Canadian Natural Resources (TSX:CNQ) which appears at the bottom of the worst performers list, down 26% on the year.  CNQ is one of the biggest players in Canada’s energy patch and has struggled, along with many others, with a tough natural gas pricing environment.  Even still, CNQ generated free cash of $252M over the last twelve months and you can bet that it is set to rebound should the commodity price(s) co-operate.

A basic fundamental

Positive free cash flow should serve as a minimum requirement when building a case to invest in a company.  There are no sure things in the investment world and the exceptions outlined above prove that this is the case for free cash flow as well.  But if you stick with this fundamental, you’re going to move the odds in your direction, and as an investor, that’s about all that you can control.