Invest Using Stocks' Price to Free Cash Flow

 |  Includes: COH, DIA, PGB, SPY
by: Friedrich Research

I have always been told by friends that the markets usually go up on average 6 days for every 4 days they go down, so the long term buy and hold investor, if he waits long enough will do great. Well as the table below shows, this is pure fiction and fantasy as the numbers show a different story. From 1928-Present (20,340 trading days) the DJIA has gone up 50.68% of the time and down 49.32% of the time. And as for the case for indexing, that is also a fantasy as a person who invested in the DJIA in 1928 and held to today, would have had an average annualized return of only 4.69% for those years. If you factor in inflation, which has averaged 3.42% annually since 1913 to today, you are left with about a 1.27% real return on your money.

10300 UP DAYS 50.68% 4.69%
10024 DOWN DAYS 49.32%
1930-1940 AVG ANNUAL % GAIN
1200 UP DAYS 48.08% -4.79%
1296 DOWN DAYS 51.92%
1940-1950 AVG ANNUAL % GAIN
1191 UP DAYS 47.64% 2.85%
1309 DOWN DAYS 52.36%
1950-1960 AVG ANNUAL % GAIN
1337 UP DAYS 53.25% 13.06%
1174 DOWN DAYS 46.75%
1960-1970 AVG ANNUAL % GAIN
1259 UP DAYS 50.58% 1.66%
1230 DOWN DAYS 49.42%
1970-1980 AVG ANNUAL % GAIN
1234 UP DAYS 48.85% 0.35%
1292 DOWN DAYS 51.15%
1980-1990 AVG ANNUAL % GAIN
1312 UP DAYS 51.90% 12.31%
1216 DOWN DAYS 48.10%
1990-2000 AVG ANNUAL % GAIN
1346 UP DAYS 53.24% 15.12%
1182 DOWN DAYS 46.76%
2000-Present AVG ANNUAL % GAIN
1252 UP DAYS 51.42% -1.82%
1183 DOWN DAYS 48.58%
Click to enlarge

So what's the answer then if Indexing doesn't work? The secret is Price to Free Cash Flow. In 2007 I completed a 58 year back test of the DJIA, which concluded that if a person invested only in stocks that had a price to free cash flow of 15 or less, they would have done great. Here is the backtest.

Now that backtest did not factor in taxes paid when one bought and sold each year, but even if half of your money was taken out for taxes you still would have done great. I then took price to free cash flow and added a second criteria, which improved my performance substantially and that is to look for quality stocks that consistently return 20%+ free cash flow return on invested capital (FROIC). Being an Investment advisor as well as an equity analyst, I am not in the habit of giving my stock picks away for free (those are reserved for my clients) but if you research hard enough you can find some real winners. The formula I have come up with is to buy stocks at 15 times(or less) their price to free cash flow and sell them when they hit 30 times or when their free cash flow return on invested capital goes lower than 10% after I have bought them originally at over 20%.

I am not a short term trader or long term investor. I am a right time investor who lets the stocks tell me when to buy them and when to sell them. In closing I should at least give you one example of a stock that has worked out well for my clients. The company is Coach (NYSE:COH) . I have been trying to buy Coach for years but it always traded above 15 times its free cash flow. In 2009 though the world became a beautiful place as the inefficient market allow the stock to fall into the low teens in price and traded at a low of about $11.41 a share. Anyone who bought the stock at that price would have paid 7 times its free cash flow per share. The company today closed at $35.19 so your gain would have been huge just six months later.

2000 27.62 17%
2001 30.44 37%
2002 43.32 26%
2003 58.98 27%
2004 45.48 30%
2005 35.85 34%
2006 37.36 36%
2007 19.48 31%
2008 10.49 44%
2009 7.98 37%
Click to enlarge

As for its free cash flow return on invested capital (FROIC) it comes in at 37%. What does this mean? A FROIC of 37% simply means that they make 37 cents in free cash flow for every $1 of total capital they invest. In the end its all about the numbers as one can not argue with the facts that they generate, just like one can not deny the performance of Warren Buffett vs. the DJIA Index. "Numbers don't lie, only people do"! So next time you talk with your advisor or broker ask them "what is the average price to free cash flow of my portfolio or what is the FROIC of this or that stock? If they can't tell you, or even worse don't know what those things mean, then it's time to find a new advisor or learn to do it yourself.

Disclosure: Long COH

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Mycroft Research, and should not be construed as personalized investment advice.

It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.