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What are we looking for?

Rising free cash flow, low enterprise value to free cash flow and good incremental operating cash flow for each dollar of increased sales.

Free cash flow (or FCF) is cash available for investors after the company has funded its cash costs, its receivables and inventory and its capital expenditures. In his book, Free Cash Flow: Seeing Through the Accounting Fog Machine, author George C. Christy, CFA, makes a compelling case for the importance and impact of free cash flow on a company's true value.

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Mr. Christy quotes Alex Pollock of the American Enterprise Institute (AEI): "Every calculation of net profit reflects choices from among competing theories of accounting. … They are matters of opinion … not matters of fact. … Profit is an opinion, cash is a fact." In addition to his work at AEI, Mr. Pollock is a seasoned banker with more than over 35 years in the industry, and is the a former president and CEO of the Federal Home Loan Bank of Chicago.

Growth investors should pay attention as Mr. Christy notes that: "All too often companies produce terrific revenue and EPS growth rates while sacrificing margins and/or using excessive amounts of capital." He adds: "A company that chronically provides revenue increases and negative cash flow does not include investor return among its priorities."

More about today's screen

In creating today's offering, I filtered the Morningstar CPMS database of Canadian companies for large firms using Mr. Christy's criteria.

In addition to companies with strong free cash flow growth and good incremental operating cash flow for each dollar of increased sales, I looked for firms with:

A market cap greater than $295-million;

No negative earnings surprises and positive estimate revisions.

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This screen follows Mr. Christy's insight. "Some of the best return candidates can be found in the bottom of free cash flow yields … companies that may have recently transitioned from negative to positive FCF and may have good prospects for continued growth."

What did we find?

Back testing – based on up to 25 stocks from September, 2004 to June, 2012, using the Morningstar CPMS database, showed Mr. Christy's criteria significantly outperformed the S&P/TSX composite index (14.1 per cent for the portfolio versus 7.5 per cent for the S&P/TSX). The median trailing P/E and EV/FCF for the portfolio is similar to the typical Canadian stock.

The median increase in year-over-year free cash flow is 90 per cent versus negative 4 per cent for the S&P/TSX. The median trailing free cash flow yield is 5 per cent versus negative 2 per cent.

The median year-over-year sales growth of 17 per cent versus 6 per cent is almost three times greater than the S&P/TSX. The median increase in incremental cash flow for each dollar of additional sales is also three times greater. This combination appears to be a significant contributor to the outperformance of the portfolio.

Robert McWhirter is president of Selective Asset Management Inc.

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