Craig McGee is a senior consultant at Morningstar Canada.
What are we looking for?
So far this year, it has been challenging to find strong performers from the broad U.S. market. The utilities sector has shown tremendous relative strength bouncing back by almost 13 per cent year-to-date, while the consumer discretionary and industrials sectors have lagged with negative returns so far in 2014. Over all, the S&P 500 has been basically flat.
With that in mind, I wanted to unearth some potentially beaten up and undervalued stocks that have also generated solid and growing free cash flow.
I scanned the CPMS U.S. database for the 20 stocks that met the following criteria:
- Market cap greater than $1-billion (U.S.);
- Positive free cash flow;
- Free-cash-flow-to-debt ratio greater than 0.5;
- Positive revision of the current year’s consensus earnings per share estimate over the past three months;
- Positive year-over-year change in free cash flow (latest four quarters).
The stocks were then ranked using the best combination of the following metrics:
- Free cash flow yield (four quarters’ free cash flow divided by latest price);
- Free cash flow margin (four quarters’ free cash flow as a percentage of sales);
- Free cash flow return on capital (four quarters’ free cash flow divided by the average debt plus equity over that period).
More about Morningstar
Morningstar Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers.
CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
The screen yielded a list of stocks that have above-average free cash flow ratios. The average free cash flow yield for these stocks is 6.4 per cent versus 5.4 per cent for the S&P 500. The average free cash flow margin is 20.3 per cent versus 14.3 per cent for the index. The average free cash flow return on capital is 21.1 per cent, compared with 12.8 per cent for the index.
Many of these stocks have been hit hard this year, but with improving expectations and solid growth prospects, they could provide a decent margin of safety with the potential for a significant upside when the market pushes ahead.
As always, be sure to do further research before investing in any of the stocks listed here.