Using Cash Flow Can Triple Your Stocks' Performance

This article republished with permission from InvestmentU.com

In my last column, I discussed the reasons why cash flow is an important metric when valuing a stock.

Today, we're going to talk about how you can use cash flow to boost the performance of your portfolios.

As I mentioned last week, price-to-cash flow (P/CF) is a useful valuation tool. Similar to the popular price-to-earnings (P/E) ratio, P/CF is calculated by dividing the stock price by cash flow per share.

We can search for stocks based on a variety of cash flow variables. But before choosing stocks based on these metrics, let's see how they actually perform as predictors of future success.

I ran a screen for stocks in the S&P 500 with positive free cash flow (the most conservative measure of cash flow) whose P/CF is lower now than it was a year ago. Because free cash flow is such an important part of a company's ability to pay a dividend, I also asked for stocks with yields greater than 2% and whose yields were in the top 20% of their respective industries.

Over the past 10 years, this group of stocks nearly doubled the overall performance of the S&P 500. The group returned an average of 11.48% per year, while the S&P generated a return of 6.01%.

An investor who invested $10,000 in these stocks 10 years ago would have $29,640 today. If the funds were invested in the S&P, he'd have $17,920.

Among the names that came up in the screen:

• Lockheed Martin (NYSE: LMT) - P/CF fell to 23.5 from 26 as free cash flow grew from $2 billion to $4.1 billion.
• Omnicom Group (NYSE: OMC) - P/CF fell to 20.1 from 27.3 after free cash flow rose from $1.2 billion to over $1.3 billion.
• ADT Corp. (NYSE: ADT) - P/CF fell to 9.1. A P/CF below 10 is an important level to value investors. That is typically considered a level at which a stock is considered inexpensive.

Let's take a look at what happens when we search for stocks with a P/CF below 10, but above zero, as I want stocks that actually have free cash flow. I also added that the companies must have generated more free cash flow over the past 12 months than they did in the prior 12 months. That way, we can ensure that we're looking at a stock that's both cheap and has free cash flow growth.

The numbers were even better than our first screen. These stocks generated an average total return of 18.54% versus the S&P's 6.01%. A $10,000 investment 10 years ago in this strategy turned into $54,760 versus $17,920 for the S&P. That's an extremely meaningful difference.

Among the stocks that came up in the screen:

• Lee Enterprises (NYSE: LEE), a microcap media company based in Iowa. It trades at a P/CF of just 2, yet grew free cash flow by 70% in the past year.
• Molina Healthcare (NYSE: MOH) offers Medicaid-related health insurance plans and has no doubt benefited from the Affordable Care Act. It trades at a P/CF of under 5 and generated nearly $500 million in free cash flow in the past year after being negative the year before.
• Nippon Telegraph and Telephone (NYSE: NTT) is a Japanese telecom giant that trades at just seven times free cash flow, yet grew free cash flow by 10% in the past 12 months. So the stock is trading below its free cash flow growth rate.

These days, it's tough to find cheap stocks. The two methods I just showed you are just two of the ways you can screen for stocks that are both inexpensive and growing. It's worth your time to learn about these and other less common variables. As you can see, the results can be quite significant.

Marc Lichtenfeld is the chief income strategist at Investment U. The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.