When to Buy Negative Free Cash Flow Stocks

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 Stock Chart by YCharts

Home Depot's negative free cash flow during this 16-year 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, had 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 26 passed the screen this month:

Mechel OAO$4,288Steel51%76%($1,683)
Oasis Petroleum$3,276Oil and Gas Exploration and Production109%109%($377)
Allied Nevada Gold$2,932Gold133%198%($43)
Tesla Motors (NAS: TSLA) $2,796Automobile Manufacturers37%385%($282)
Energy XXI (Bermuda)$2,588Oil and Gas Exploration and Production58%155%($857)
Molycorp (NYS: MCP) $2,473Diversified Metals and Mining388%724%($160)
Opko Health$1,591Biotechnology134%193%($15)
MAKO Surgical$1,519Health-care Equipment59%42%($33)
Vanguard Natural Resources$1,407Oil and Gas Exploration and Production141%90%($62)
Legacy Reserves LP$1,357Oil and Gas Exploration and Production57%84%($108)
Approach Resources$1,068Oil and Gas Exploration and Production47%133%($173)
Insulet$918Health-care Equipment52%114%($37)
Heckmann$735Soft Drinks95%180%($112)
Velti$513Internet Software and Services91%34%($58)
Rex Energy$488Oil and Gas Exploration and Production48%77%($177)
Amyris$483Oil and Gas Refining and Marketing129%57%($164)
RealD$473Electronic Equipment and Instruments114%137%($52)
OCZ Technology Group (NAS: OCZ) $400Computer Storage and Peripherals45%96%($78)
Alexco Resource$384Precious Metals and Minerals242%36%($25)
Syneron Medical$379Health-care Equipment101%61%($37)
Vantage Drilling (ASE: VTG) $337Oil and Gas Drilling147%56%($699)
Triangle Petroleum$318Oil and Gas Exploration and Production450%423%($109)
A123 Systems$275Electrical Components and Equipment26%106%($423)
Rubicon Technology (NAS: RBCN) $259Semiconductor Equipment207%200%($11)

Source: S&P Capital IQ.

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.

Rare-earth mineral miner Molycorp is one of the most-followed companies out there, and is one of the riskiest stocks on my list. Its price has largely been tied to the whims of China's export quotas, but that may change in the coming years. It's intriguing, but this one is probably too risky for my portfolio at this time.

OCZ Technology Group has rocketing revenues and rising margins, and management's planning to keep growing aggressively. I need to keep an eye on the quality of its acquisitions, but this maker of solid-state drives is a possibility.

Rubicon Technology, which makes crystalline products for LEDs, lasers, etc., deserves consideration because it shares a couple of more traits with the early Home Depot, beyond what I screened for: (1) Its cash from operations has turned positive and is growing, and (2) it's profitable on the income statement.

Vantage Drilling provides offshore contract drilling services. It's small, not widely followed, and boasts 40% insider ownership -- all positives in my book. It currently operates four jackup rigs and three drillships, and seems to have a lot of growth ahead of it.

Many of you may be interested in Tesla Motors. I am also, but I don't think it fits well with the spirit of this screen. Unlike Home Depot -- which was reinvesting heavily into a proven concept -- Tesla's success depends on how well the mass market will take to plug-in electric vehicles.

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 it out here, and add the page to 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 "One Stock to Own Before Nat Gas Act 2011 Becomes Law."

At the time this article was published Fool analyst Rex Moore has installed screen doors on his personal submarine. He owns no companies mentioned here. The Motley Fool owns shares of Amyris, Heckmann, MAKO Surgical, Seaspan, and Zipcar. Motley Fool newsletter services have recommended buying shares of Tesla Motors, Zipcar, and MAKO Surgical, as well as writing a covered straddle position in Seaspan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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