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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 14293  
Subject: If cash is king, where to look? Date: 10/25/2008 11:05 AM
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Many great value investors believe that high free cash flows will
always get recognized. Mr Buffett points out that great companies
are often drowning in cash.

Given the huge falls in price lately, I was looking at some of the
amazingly solid companies out there. Without trying to get too much
into the economics are of the businesses, I just whipped up a little
screen to look for drowning victims.

First, for practical reasons, the company has to be in my Value Line "Plus" database of 7419 stocks.

Next, it has to have a "Financial Strength" rating of A+ or A++, leaving a mere 122 firms.
Though you can never guarantee safety, these are firms which are
generally regarded as having a very safe position.
Even with no sales for a long while it's hard to kill a company with a really strong balance sheet.

Next, the debt servicing can't be a problem: total debt has to be low
enough that it could be paid off in under 5 years of earnings at the
current rate. This uses Value Line's "current earnings" definition, which
is the trailing 2 quarters of actual earnings plus two quarters of forecast.
The debt side of the ratio is long term debt plus current liabilities less cash.
This leaves 97 firms.

The free cash flow of the firm has to be over 5% of the market cap.
For every dollar worth of stock, not only are they making a profit,
but they are generating 5 cents of hard cash that they don't need
even after continuing their trend capital expenditure program.
This is a very stringent condition, but we have already had some
stringency so it isn't obvious from the company count, now down to 46.

The current earnings yield has to be over 10%, or P/E ratio under 10 if
you like, based on the same definition of current earnings.
This leaves 26 firms.

Lastly, another balance sheet test: their "Graham net-net" ratio
has to be over 5%. Mr Graham once suggested that a large collection of
firms bought for less than their "net-net" value should give
satisfactory returns, no matter what else would be true about the firms.
I'm not that strict, since these are firms with strong earnings and
cash generation, but I do want some safety. So, my formula is this:
Realizable liquid assets after all debt paid / market cap > 5%
Where---
Realizable liquid assets = cash + 25% of inventories + receivables + annual cash flow
All debt = current liabilities + long term debt
Note, I have the rather odd addition of cash flow in the liquid assets
because this is a formula normally used when contemplating a shutdown
scenario. By the time you shut down a firm, it has usually either
burned or earned cash for a year, which is why it's in there.
This final test leaves 15 firms.
Note, these tests won't work for financial firms, but as it happens
the filter doesn't suggest any at the moment (wonder why?).

I speculate that a shotgun investment in these firms will do well.
You're getting a lot of cash, a lot of cash flow, and a lot of earnings
for your money, without much debt measured in a couple of different ways.
This is all using hindsight cash flow and earnings, which we blithely
simply assume will come back after the recession giving us good long
run returns, and covering any errors in the assumption through diversification.
Note, I think that when things pick up the oversold energy and
materials sectors will not only rebound but be leaders at some point;
after the chaos calms down, there is still a lot of stuff to be built.
So, again, I am blasé about using mostly trailing figures.

The final sort is by "free cash flow / enterprise value"
This is a nice metric for buyout guys: if you bought the whole firm and
paid off all the debt, how much cash would you get every month even
after maintenance capex with which to service any debt you used for the purchase?
Or, phrased another way, what's the highest interest rate you could
pay and still have an LBO make free money for you?
I have observed that Berkshire Hathaway generally won't be seen
buying a firm with FCF/EV under around 10%.

Anyway, here are the picks, in decreasing FCF/EV order.

Abercrombie and Fitch (specialty retail) 25.01, 40.6%
Franklin resources (financial, but asset management, not a bank) 55.48, 33.3%
Royal Dutch Shell (integrated oil) 46.78, 32.3%
Occidental Petrolium (integrated oil) 45.69, 25.6%
Imperial Oil (integrated oil / Canada) 30.31, 23.0%
Nucor (steel) 35.01, 22.8%
Garmin (electrical equip) 21.26, 21.0%
Texas Instruments (semiconductors) 16.95, 20.2%
Nokia (telecom equipment) 15.44, 20.0%
Exxon (integrated oil) 69.04, 18.5%
Ingersoll-Rand (machine) 17.07, 18.4%
Illinois Tool Works (metal fabrication) 30.50, 17.0%
Eli Lilly (drugs) 31.73, 13.7%
eBay (internet) 14.89, 13.1%
Wyeth (drugs) $32.39, 12.4%

I believe that under normal conditions you would not find any US
companies passing all these tests. Metaphorically you are looking
at a bunch of rich guys who have just been knocked down. You notice
their bulging wallets (with cash, not cards!) and bet that they will get
back up again and still have high-paying jobs.

Let's check back in a few years' time...

Jim
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