Free Cash Flow Cows strategy

Free Cash Flow Cows strategy

Free Cash Flow Cows is a deep value bargain strategy inspired by the investment writer, Jae Jun at Old School Value. It looks for companies that appear to be cheaply priced compared to the amount of free cash flow they generate. In particular, they should be stable, cash rich companies where free cash flow is actually growing. Among the ratios used in this strategy is Enterprise Value to Free Cash Flow and Free Cash Flow to Long Term Debt. Jae Jun says: "When it comes to true profitability, forget earnings and EBITDA. Free Cashflow is by far the best number to refer to." Jae Jun's backtesting of his own FCF Cows screen found that it beat the S&P 500 in six out of nine years between 2001 and 2009.
Criteria
Free cash flow as an indicator in the search for stocks is particularly popular among bargain investors because it can offer a greater degree of accuracy in establishing a company's intrinsic value - its real value as opposed to its market value. While other measures such as assets and earnings can ultimately be understated or even manipulated by crafty management, FCF is more transparent.
Using free cash flow as a valuation metric is a central philosophy of Bruce Berkowitz, a star fund manager at the US-based Fairholme Fund. His adherence to the bargain investing philosophies of Benjamin Graham sees him focus on companies with good management, positive free cash flow and are cheaply priced. Describing his approach, he claimed: "At Fairholme Fund, our trademark is we ignore the crowd. So we pay attention to what matters and what matters is cash. We count cash, ignore the crowd."
The Free Cash Flow Cows screen looks for cash rich companies growing their FCF, yet selling at a cheap multiple to FCF. The screen is inspired by a methodology developed by Jae Jun on the excellent Old School Value US blog, who advocates the use of FCF for the intrinsic valuation of a company. That approach looks for stocks that are cheap on an Enterprise Value to Free Cash Flow basis but consistently growing their FCF, which should in turn lead to improving valuations. You can also see another interesting US screen variant here.
Traditionally, cash cows tend to be larger, slow-growth companies with dominant market positions. They throw off lots of cash with which they can reinvest in future growth or pay dividends to investors. The nuance with the Free Cash Flow Cows screen is a focus on companies that are increasing their free cash flow, reducing debt and boast relatively attractive valuations on an EV to FCF basis. This means that smaller stocks (that are potentially cheap to buy) are more likely to qualify for the screen.
We have modelled the Cows screen for UK stocks, selecting companies where the EV / FCF ratio is less than 10, where the ratio of FCF to long term debt is falling and where FCF has been increasing over the previous three years. To add an extra layer of comfort and attempt to strip out rogue results, we also look for companies where FCF is more than 5% of sales revenue. Companies are then ranked on EV to FCF.
This strategy uses the following checklist:
FCF / LT Debt > FCF / LT Debt PTTM
FCF / LT Debt > 10
EV / FCF < 10
FCF > FCF 1y Ago
FCF 1y Ago > FCF 2y Ago
FCF 2y Ago > FCF 3y Ago
FCF > 0.05 * Sales (Local)