Cash flow is king – and here’s why

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.  

We are also wary of businesses that report strong profitability on relatively low operating cash flows. It can indicate a change in payment terms – paying debtors later and demanding payment sooner. Not necessarily bad, but the benefits are only felt in one year. They can’t be sustained. 

Asking more questions

The cash flow numbers are a starting point – they show us where more digging is required and which questions to ask. Is that rise in profits with no accompanying rise in free cash flow because you’ve just booked a big order at year end on your accounts but are still waiting for payment to come through? Why are you investing such a big proportion of your operating cash flows in taking your business online? Do the potential benefits justify the expenditure?

We tend to avoid businesses using operating cash flows to finance M&A activity – too often it fails to deliver the anticipated benefits, but sometimes we agree with management that an acquisition opportunity has to be grabbed. 

And we dislike debt. We don’t like seeing debt repayments take a chunky bite out of operating cash flow. But if, for example, it’s to commercialise a new technology that has massive potential globally, we would be foolish not to exploit the opportunity. 

So, cash flow analysis is a science and art. It is time consuming and often only leads to more questions, prompting further research. 

Sustainable dividends

Companies that pay attractive dividends are a valuable component of any portfolio, but those dividends must be sustainable. It is the business’s cash flow data that tells you whether the cheques will keep coming and hopefully some time before you find yourself looking down and wondering where the road has disappeared to.

Andy Marsh works alongside Adrian Frost and Nick Shenton as part of Artemis’ income team

For professional and/or qualified investors only. Not for use with or by private investors. This is a marketing communication. Refer to the fund prospectus and KIID/KID before making any final investment decisions. Capital at risk. All financial investments involve taking risk which means investors may not get back the amount initially invested.

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