- Investment decisions taken by company managers to support their forecasts often create profit expectations in the stock market that are unsustainable.
- Errors in company profit forecasts are magnified in stock markets as investors adopt unreliable company forecasts to value future profits. These errors are predictable and identifiable and create our investment opportunities – particularly at key stages of a company’s development.
- The best way to exploit these investment opportunities is to focus on company cash flow.
- Strong company cash flows (after investment spending) are a good indicator of strong growth in future reported profits. Conversely, weak cash flows often predict a collapse in reported profits.
- We buy companies with strong cash flows which are likely to beat investors’ low profit expectations, and sell companies with strong cash outflows likely to disappoint investors’ high profit expectations.
How do we identify companies with strong cash flows and low profit expectations?
We use two cash flow measures: cash flow relative to operating assets and cash flow relative to enterprise value. These ratios tell us:
- How much cash a company generates on its investments.
Good companies have high returns on cash invested and low requirement for substantial investment.
- How investors value a company’s cash flow.
Good companies have high cash flows relative to their market value; they are priced cheaply because investors have low expectations for profits growth.
We rank companies on these two measures; by selecting companies with the best combined score, we generate a list of stocks cheaper than the market (as measured by cash flow yield) with cash returns on operating assets which are better than the market. Stocks with this combination have outperformed the market in the past, and we believe they will continue to do so in the future.
Constructing our portfolios
For each stock universe for our portfolios, we use our combined measure to identify the best 20% of stocks (our “top quintile”) as our list of possible buys. Within this list, we set out to understand each business we invest in. We make sure that the cash flow data is indicative of the type of forecast errors we are hoping to exploit. We believe these stocks will deliver profits significantly better than investors’ expectations and generate good investment returns.