High Free Cash Flow = Bad Investment?

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Most of us at The Motley Fool, including me, love free cash flow. But if we take that obsession too far, we'll buy into companies we shouldn't, and miss out on some truly great stocks.

Today, I'll show you how to avoid that mistake -- and give you my monthly list of stocks with negative free cash flow that might be poised for greatness.

Good FCF, bad FCF
We love free cash flow for a number of reasons, mainly because it gives us a more realistic view of a company's earning power. Yet as you've probably learned if you've been investing for more than a few days, nothing is ever simple in the world of stock picking.

Joel Litman, managing director at Equity Analysis & Strategy, is one of the top experts around when it comes to evaluating cash flows. At a recent presentation at Fool HQ, he pointed out that there are times to buy heavily into a company with negative free cash flow. Determining "good negative free cash flow" and "bad negative free cash flow" begins with a look at a company's rate of return alongside its rate of growth.

Big orange
The perfect example is Home Depot. The home improvement retailer absolutely plastered the market from 1985 to 2001, yet showed negative free cash flow in all but one of those 16 years.

Home Depot's negative free cash flow during that period was the result of management pouring all its cash back into its high-return business -- and not because of any deficiency in the business itself. "As long as that growth in capital will realize returns above the cost of that capital," Litman says, "negative free cash flows can be a great sign for the business."

In 2001, Home Depot finally hammered out positive free cash flow and has maintained that positivity every year since. Its stock price, however, has been relatively flat.

Litman says the market has understood the issue very well, namely that the positive free cash flow was the result of management slowing its rate of reinvestment back into the business. This is sometimes accompanied by share buybacks, dividend boosts, and other "good things for investors." However, he says, "None of these can be as good for shareholders as massive growth into an incrementally high return business."

If a company you own is transitioning to this stage, you may want to consider that its high-return days are behind it.

The next Home Depot
The natural question, then, is which companies today are exhibiting characteristics similar to Home Depot in the early part of its high-growth, negative-cash-flow phase?

I set up a screen for all companies on U.S. exchanges with a market cap greater than $200 million that have:

  • Grown their revenues an average of 25% or more over the past two years.
  • Grown their capital expenditures an average of 25% or more over the past two years.
  • Generated negative free cash flow each of the past two years.

Because we're looking for younger businesses early in their growth cycles, I also limited the results to companies that were founded since 2000. Just 17 pass the screen this month:

Mechel OAO

$4,358

Steel

51%

76%

($1,683)

Molycorp (NYS: MCP)

$2,903

Diversified Metals and Mining

648%

544%

($259)

Oasis Petroleum

$2,852

Oil and Gas Exploration and Production

196%

173%

($437)

Legacy Reserves (NAS: LGCY)

$1,426

Oil and Gas Exploration and Production

57%

202%

($23)

Vanguard Natural Resources (NYS: VNR)

$1,530

Oil and Gas Exploration and Production

161%

49%

($65)

Iridium Communications

$676

Alternative Carriers

125%

599%

($176)

Rubicon Technology

$247

Semiconductor Equipment

160%

195%

($24)

Allied Nevada Gold

$2,828

Gold

88%

188%

($64)

RealD

$654

Electronic Equipment and Instruments

51%

95%

($36)

Seaspan (NYS: SSW)

$1,032

Marine

41%

28%

($486)

Le Gaga Holdings

$209

Agricultural Products

44%

46%

($20)

Alpha & Omega Semiconductor

$245

Semiconductors

25%

125%

($14)

Kosmos Energy (NYS: KOS)

$5,149

Oil and Gas Exploration and Production

2,299%

71%

($118)

iSoftStone Holdings

$516

IT Consulting and Other Services

67%

82%

($42)

Approach Resources

$1,215

Oil and Gas Exploration and Production

58%

145%

($189)

Suntech Power Holdings

$643

Semiconductors

43%

61%

($287)

Alexco Resource

$421

Precious Metals and Minerals

242%

36%

($25)

Data provide by S&P Capital IQ. TTM = trailing 12 months.

We're left with a list of young, mostly small companies that are investing heavily back into their high-growth businesses -- just as Home Depot was doing in 1985.

Molycorp has been a mover and shaker this month, announcing it will buy Neo Material Technologies, a processor of rare-earth minerals, for $1.3 billion. With this and other deals, management is hoping to mitigate the effects of volatile raw rare-earth minerals prices. Molycorp's stock is up 20% since the announcement.

Seaspan has performed well over the last few weeks. The container ship operator has an outstanding business model: Its new ships are immediately tied to 12-year charters, on average, with major shipping companies.

It's very interesting to see so many oil and gas companies on the list: Vanguard Natural Resources, Legacy Reserves, Oasis Petroleum, and Kosmos Energy. While the first three are domestic drillers, Kosmos focuses on "under-explored regions" in Africa. The Jubilee Field off the coast of Ghana gave the company its first revenue last year, and it's looking to develop more discoveries while continuing exploration. This is definitely a contender for my portfolio.

Winners and losers
As is the case with all of my screens, this one is now being tracked and scored so we can measure exactly how it's performing. Check my "Next Home Depot" CAPS page here, and mark it as one of your favorites. You can also follow me on Twitter to keep up with all my screening fun.

Meanwhile, one negative free cash flow company that didn't show up on my screen is interesting for another reason: It's well-positioned to take advantage of the natural gas boom. Find out more in our special free report "The One Stock You Need to Own for the Coming 'No Choice' Energy Revolution."

At the time this article was published Fool analyst Rex Moore had a dream and it filled him with wonder; she had other plans. He owns no companies mentioned in this article. The Motley Fool owns shares of Seaspan and Iridium Communications. Motley Fool newsletter services have recommended creating a covered straddle position in Seaspan. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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