What are we looking for?
U.S. stocks with strong cash flow.
Examining a company’s cash flow, or lack thereof, can give a good indication as to its financial health. Excess cash flow is indicative of a company’s ability to take on new projects, to pay dividends to their shareholders, to reduce their debt, etc., whereas a lack of cash flow makes any one of these items much more difficult, if not impossible, to achieve. The term “free cash flow” simply refers to the cash a company has left over after any capital expenditures, such as equipment or property.
Today, I’m showcasing a strategy that looks for U.S. companies with strong cash flow compared with their peers. We screened the entire CPMS universe of U.S. stocks, which currently comprises 2,174 names. The strategy ranks stocks based on: free cash flow yield (a profitability metric, higher values preferred); trailing free cash flow (latest four quarters’ free cash flow, higher values preferred); five-year sales growth (annualized, higher values preferred); and five-year dividend growth (annualized, higher valued preferred).
In order to qualify for purchase, stocks were required to have:
- Free cash flow yield in the top one-third of peers (today this value is greater than 4.1 per cent);
- Trailing free cash flow in the top one-third of peers (today this value is greater than US$2.57 a share);
- Dividend payout ratio less than or equal to 80 per cent (to avoid companies not retaining earnings for growth);
- Five-year annualized sales growth greater than zero;
- Five-year annualized dividend growth greater than zero;
- Five-year annualized earnings per share (EPS) growth greater than zero.
More about Morningstar
Morningstar Research 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
I used Morningstar CPMS to back test this strategy from April, 2004, to May, 2018. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their free cash flow yield or trailing free cash flow were in the bottom third of peers, or if their dividend payout ratio was greater than 90 per cent. When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 13.8 per cent while the S&P 500 Total Return Index returned 8.8 per cent across the same period.
Stocks that qualify for purchase into the strategy today are listed in the table below. As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.