What are we looking for?
Companies on the S&P 500 that have good cash flow characteristics.
Companies that have been able to generate strong earnings momentum have done well over the past year, but it’s equally important for these companies to be able to turn those earnings into cash. It can be very challenging for companies to generate cash flow during difficult economic times.
Unlike the income statement, it’s more difficult for companies to manipulate cash. Profit is an accounting concept whereas cash is more like a business’s chequing account. Furthermore, the cash flow statement often provides better key performance indicators than the income statement and can be a great place to see how a company is able to generate cash from its operations and investments. High positive cash flow indicates a company will be able to make profitable investments and boost its business organically and provide good long-term investment returns. By focusing on companies that are generating good cash flow we can find stocks that are able to do well during economic turmoil.
Today I use Morningstar CPMS to look for stocks that have a relatively large market capitalization with strong cash flow momentum. Here I have measured cash flow momentum on a quarterly, annual and three-year basis to get a good range of a company’s ability to consistently generate cash. (Quarterly cash flow momentum is the latest four quarters of cash flow from operations per share compared with the same figure from one quarter ago. Annual cash flow momentum compares the latest four quarters of operating cash flow per share with operating cash flow from four quarters ago.)
I also want companies that are not taking on excessive amounts of debt because these companies might have solvency and liquidity issues down the road. Therefore, I want companies that generate higher cash flow relative to the amount of debt that they have. I also do not want to be exposed to companies that have extreme swings in the market price. Looking for companies that have a lower standard deviation in price can reduce the risk of mistiming the market.
In summary, larger companies that have been able to generate really good cash flow over time and do not have a stock price with extreme ups and downs should be able to provide strong returns for investors throughout the entire market cycle.
First, we ranked our stocks from one to 500 according to six key factors: quarterly and annual cash flow momentum; three-year annualized cash flow growth; cash flow to debt; 180-day standard deviation; and market capitalization.
Next, we applied three screens to create our list of stocks:
- Market capitalization above US$7-billion;
- Three-year normalized cash flow growth greater than zero;
- Cash flow to debt greater than 0.2.
What we found
I used CPMS to back-test the strategy from January, 2006, to December, 2020. During this process, a maximum of 15 stocks in the S&P 500 were purchased and equally weighted. Stocks would be sold if their overall rank dropped out of the top half of our list. The portfolio is rebalanced monthly and the strategy produced an annualized total return of 14.9 per cent since inception, whereas the S&P 500 Total Return Index advanced 9.7 per cent on the same basis. For calendar year 2020, the strategy produced an outstanding one-year of return of 48.4 per cent compared with 18.4 per cent for the S&P 500.
Only 14 stocks qualify for purchase into the strategy and are listed in the accompanying table. As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Phil Dabo, MFin, is a director, CPMS sales at Morningstar Research Inc.
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