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'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, 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 12 passed the screen this month:

Mechel OAO$4,437Steel51%76%($1,683)
Legacy Reserves$1,399Oil and gas exploration and production57%84%($108)
Oasis Petroleum$3,045Oil and gas exploration and production109%109%($377)
Molycorp$2,354Diversified metals and mining388%724%($160)
Vanguard Natural Resources$1,456Oil and gas exploration and production141%90%($62)
Rubicon Technology (NAS: RBCN) $275Semiconductor equipment207%200%($11)
RealD (NYS: RLD) $675Electronic equipment and instruments51%95%($36)
Allied Nevada Gold$2,871Gold133%198%($43)
Alpha & Omega Semiconductor$262Semiconductors25%125%($14)
Approach Resources$1,189Oil and gas exploration and production47%133%($173)
Alexco Resource$459Precious metals and minerals242%36%($25)

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.

The first one I'm digging into this month is Rubicon. It has positive cash from operations and positive earnings on the income statement. Its return on equity is in the 20% to 25% range, evidence of a strong competitive advantage. However, with a market cap of $275 million, it's small and volatile.

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. I started the tracking last month, and in that time RealD is up more than 40%. It has been down big over the last year, but better-than-expected earnings have the stock on the rebound. Nearly 20,000 theaters are now using its 3-D projectors.

Looking back at some other stocks from last month, Tesla Motors (NAS: TSLA) is up more than 20%. The company reported decent earnings and gave indications that its first mass-market car, the Model S, may make it by this summer as planned.

Synthetic biology company Amyris (NAS: AMRS) , meanwhile, is down more than 40% after management revised guidance. The company will not achieve positive free cash flow in 2012, and needs to raise additional equity financing. Amyris didn't pass the screen this month, and will be removed from the CAPS tracking page.

Keeping up...
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 "One Stock to Own Before Nat Gas Act 2011 Becomes Law."

At the time this article was published Fool analyst Rex Moore reminds you that all you touch, all you see, is all your life will ever be. He owns no companies mentioned in this article. The Motley Fool owns shares of Seaspan and Amyris. Motley Fool newsletter services have recommended buying shares of Tesla Motors and 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.

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

Read Full Story