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A common meme of old Warner Bros cartoons is Wile E. Coyote racing along a road that suddenly disappears over a cliff edge. The character somehow keeps running for a few feet till, legs whirling mid-air, his situation becomes apparent to him. Only when he has noticed the peril he faces does gravity finally kick in. Terrified, he crashes into the chasm. This was considered hilarious children’s entertainment in the ’60s and ’70s.
It’s a tad melodramatic as an analogy, but one that may resonate with anyone watching the performance of some of the iconic US growth stocks this year – in particular those that have dived 50% or more from their 2021 heights.
As inflation has settled in, and with interest rates rising, shareholders have begun to scrutinise more carefully the growth forecasts and cash flows and started questioning the return on capital invested.
In our experience, analysing the path and progression of cash flows is a vital part of fund management. Cash flow is the road beneath a business’s feet. We like businesses with a smooth and certain path. We prefer to know beforehand if we’re approaching any cliff.
Cash flow first
Investors, naturally, gravitate towards profitable companies. But we cannot assume today’s profits will be maintained tomorrow. When a company pays a generous dividend, it does not mean it will repeat the exercise next year.
This is why our mantra has always been cash flow first, dividends second. Specifically, we look at free cash flow. This is the money the company has left over after it has settled all its bills and invested in its future. It is the pool of capital available for distribution to shareholders.
Digging into the numbers
You can find this information in companies’ reports and accounts, but it may require deeper interrogation and analysis. The key figure to identify is the operating cash flow declared by the business. This offers a snapshot of the core business’s cash flow position. From this, subtract tax due, interest payments and capital expenditure to establish a figure for free cash flow.
Don’t just look at a single year because cash flow can be volatile in the short term. There can be good, acceptable reasons for this but it can be a red flag too.
Growing, catching up or treading water?
A business that is consistently allocating a large share of its operating cash flow to capital expenditure may have systemically under-invested for a long period. Or it may be operating in an industry threatened by structural change. The oil industry investing heavily in renewable energy projects is a great illustration of this. We want companies to stay up to date, but we also need to know how much this might cost.