What are we looking for?
Companies with a strong track record of free cash flow that make significantly more money than they need to operate and that can create shareholder value by paying dividends, repurchasing stock and making acquisitions.
While most investors look at a stock's price-to-earnings ratio (or its inverse, the earnings yield) as a rough barometer for how expensive a stock is trading, at Lorne Steinberg Wealth Management we tend to look beyond simple "accounting" profit and pay much closer attention to a company's ability to generate cash. As such, we are focusing today on a company's "free cash flow yield" as free cash flow tends to be far more indicative of the actual returns that shareholders receive from owning a business.
The screen
My colleague Brian Pinchuk and I used S&P Capital IQ to screen for companies in North America that have a market capitalization of more than $1-billion (U.S.). As value investors, we eliminated companies trading at nosebleed valuations by restricting our screen to companies with multiples – forward P/E ratio, price-to-tangible book value and total debt-to-equity ratio – that were not in the stratosphere.
Above all, we wanted to home in on companies that produce healthy free cash flow (FCF) – specifically, an average FCF yield of more than 5 per cent over the past five years.
Finally, in order to reduce the impact of anomalies, we narrowed the list down to only those companies that generated positive free cash flow in each of the past five years. (In this case, we used "levered" free cash flow, as defined by S&P Capital IQ. This is a more conservative definition of FCF as it takes obligations on debt into account).
What we found
Several companies on the list are in the commodity space – an unsurprising result given the boom in many commodity prices (until recently, of course). Heading that list is Teck Resources Ltd.. The company's average FCF yield over the past five years exceeds 20 per cent. With a sharp decrease in the prices of its main products, such as metallurgical coal and copper, their ability to generate cash has been facing headwinds, which will likely continue in the short term.
Domtar Corp. also ranks high on the list, with a very high average FCF yield. The company is arguably reasonably priced, trading at multiples that do not appear lofty. However, more than 80 per cent of its current sales are derived from pulp and paper. With many paper-based products in secular decline, it is attempting to restructure and grow its personal-care segment. Sales in that division have been progressing nicely due to growth in its adult incontinence products.
Investors are advised to do their own research before purchasing any of the stocks listed here.
Samuel Oubadia is a portfolio manager at Lorne Steinberg Wealth Management in Montreal.