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Thursday, November 21, 2013 - 14:30

The One 'Secret' Trait That Makes A Good Stock Great

Thursday, November 21, 2013 - 2:30pm

$388.5 billion is a staggering figure. It's more than the entire economy of Thailand, Denmark, Colombia or the United Arab Emirates.

And it's how much operating cash flow was generated by America's top 12 companies in 2012.


Source: Thomson Reuters

Of course, the old adage "It takes money to make money" applies. Many of these companies need to spend billions of dollars in research, infrastructure and other areas to generate that cash flow, and their actual take-home pay is a lot less. Exxon Mobil (NYSE: XOM), for example, spent more than $34 billion on capital expenditures last year, sapping a considerable chunk of its $56 billion in operating cash flow.

As a bit of silver lining, these companies spend much of that on goods and services offered by other companies, creating a virtuous circle of corporate spending. Here are the top 12 capex spenders of 2013.


Source: Thomson Reuters

The number of oil and gas firms in this group explains why an energy services provider like Schlumberger (NYSE: SLB) sports a $120 billion market value, but is not truly a household name.

The True Measure
Unfortunately, even as many Wall Street analysts wisely avoid a simple focus on net profits, their decision to value stocks in the context of operating cash flow is also mistaken. It's irrelevant that Exxon Mobil generated $56 billion in 2012 free cash flow. After capital expenditures are deducted, free cash flow falls by more than half to $22 billion. It's still an impressive figure, but knocks the oil giant from the leaderboard.

Rather than focus on operating cash flow, check out a company's free cash flow, which is the only bankable source of stock buybacks, dividends, acquisitions and debt pay downs. Indeed some of the top-performing stocks in today's market share some of all of those characteristics. Here's a look at the top 12 companies in America in terms of free cash flow.


Source: Thomson Reuters

It's no coincidence that technology stocks make up almost half of the group. Tech businesses, especially software, are considered to be "asset light," which means they have to make relatively few capex investments to support their business.
Apple (Nasdaq: AAPL), with its roughly $45 billion in free cash flow in 2012, is a great example. Earlier this year, when shares of Apple had fallen all the way to $400, I suggested that a share buyback would be a great use for that free cash flow. The next month I argued that a judicious use of debt leverage would enhance that buyback even more. (With shares of Apple now up more than $100 since then, I'm not sure that buybacks are still the way to go, as Carl Icahn is currently clamoring for.)

Do The Math
Remarkably, many Wall Street reports neglect to mention a company's free cash flow. But they often do mention operating cash flow (OCF), and occasionally, capital spending. From there, you can just do the math yourself, subtracting capex from OCF.

The next step is to derive the free cash flow yield, which is a company's free cash flow divided by its market value. Absolute free cash flow is impressive, but it's not always quite as impressive in relation to a company's worth. Here's a look at the top 12 companies in the S&P 500 in terms of free cash flow yield.


Source: Thomson Reuters

Both Morgan Stanley (NYSE: MS) and insurance firm MetLife (NYSE: MET) dominate this group, but they are quite different in terms of their financial markets exposure. Morgan Stanley operates in a range of risky and cyclical segments of finance. As a result, the Wall Street firm has generated negative free cash flow on three or four occasions over the past decade.

In contrast, MetLife eschews risk and is boringly predictable. As I noted last month, MetLife and other insurers should deliver even more robust free cash flow once interest rates start to rise. So the FCF yield in the context of future results is even more appealing.

Risks to Consider: It's already been nearly a half decade since the last U.S. recession -- but when the next one arrives, these firms' free cash flow capacities will be challenged.

Action to Take --> If you are focusing on buying a stock after you've fully researched its background and prospects, take the final step and examine its free cash flow and free cash flow yield. Low levels of free cash flow, which typically result from high levels of capex, can prevent a company from shareholder-friendly moves at stock buybacks and dividend hikes.

P.S. Investing doesn't have to be complicated: Invest in simple businesses that generate billions of dollars that they can return to their shareholders through dividends and buybacks. It works. In fact, the stocks in our latest research report, "The Top 10 Stocks For 2014," have outperformed the market threefold over the past five years following this simple strategy. To learn more about our top picks for 2014 -- including several names and ticker symbols -- click here.

 

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.