2010 Stock Selection: Is Free Cash Flow the Way to Go?

by: James Levy

Never during my twenty years of experience as an investment advisor can I recall as wide a disparity as there is today concerning the outlook for the stock market in 2010. During the past weeks I have read many ¨The Year Ahead¨ articles by almost all of the investment analysts whom I respect the most.

Unlike Al Gore´s Global Warming, there is no consensus, not even concerning the most basic elements of what might be in store in the coming year. Will we experience a sharp increase in inflation due to the Federal Reserve´s accountable to no-one quantitative easing combined with the Obama/Pelosi/Reid drunken-sailor deficit spending? Or, rather, are we on the way to a Japan style deflationary spiral, with chronic high unemployment, sagging real estate values and declining money creation, due to the ongoing collapse in the velocity of money, as the frightened still-employed save as much as possible? At this point very good arguments can be advanced to support either the inflationary or the deflationary thesis.

The domestic political scene and the international political situation only add to the overall air of uncertainty. How will the hastily designed Obamacare bill impact the one sixth of the American economy linked to health care? Will the Obama/Pelosi/Reid Troika force through an enormous tax increase next under the guise of protecting the environment with Cap and Trade? Will the domestic terrorism incidents continue to multiply in the coming months? Will Israel eventually strike Iran to prevent that regime from gaining nuclear weapons which it has vowed to use against the Jewish state? Will the United Kingdom go bankrupt even before Greece, leading to a global sovereign debt crisis of such proportions that we will become nostalgic for the ¨manageable¨ global banking crisis? This list could continue for pages, but I will spare the reader this particular cruelty.

Faced with all of the above, I am wary of long duration bonds, as inflation may accelerate, devastating their value. At the same time, short term bonds offer very meager returns in the current low interest rate environment. As for equity, after the run up since March of 2009, I am not eager to jump on the bandwagon of emerging markets or low quality ¨growth¨ shares which have provided the highest returns in the past several quarters. Given these considerations, where to turn now?

I believe that the coming months will reward investors who focus now on buying shares of companies which generate excess cash after their expenses and necessary capital investments are met. In an environment where banks are not lending freely, and consumers are spending sparingly, even as ¨green shoots¨ are wilting, companies which are functioning correctly in their capacity as cash generation machines should be able to command a premium valuation in the stock market. In short, I believe that investors should focus on free cash flow as the key valuation indicator during the current uncertainty. Companies with healthy free cash flow will be able to survive restrictive bank lending practices as well as possible disruptions in the currently strong market for new corporate debt. At the same time, companies with high levels of free cash flow will be better placed to acquire competitors who stumble in 2010 due to excessive leverage in a restrictive credit environment.

If ¨Cash is King¨, free cash flow is the path to royalty, to quote Tom Shohfi from his excellent article in Seeking Alpha in June of 2009, ¨10 Small Cap Stocks with Double-Digit Free-Cash-Flow Yields¨. While I am now recommending free cash flow as a valuation guide to reduce equity risk in the case of difficult stock markets in 2010, the ten shares recommended by Tom Shohfi in June have given an average return of nearly 40% between mid-June and the first week of 2010, double that of the 19% of the Russell 2000 index in the same time period. A focus on high free cash flow is a strategy which should benefit investors in 2010 both under a bull or a bear market scenario.

To find shares for new investment in the past week I have run my own screens using the excellent free program available at FINVIZ.COM financial visualizations. I screened for shares with a free cash flow yield (that is, free cash flow per share divided by share price) of 10% or more, a current and estimated earnings P/E of 15 or less, and net positive insider (insider buying) transaction activity during the past six months. Even under these very restrictive conditions, I gained a list of over twenty companies, among them Interactive Brokers (NASDAQ:IBKR), UFPT Technologies (NASDAQ:UFPT), Endo Pharmaceuticals (OTCPK:ENDO), Iteris Inc.(NYSEMKT:ITI) and Republic Airways Holdings (RJET), even after discarding the banking and insurance companies due to my inability to evaluate their balance sheets.

In conclusion, I believe that free cash flow will prove to be a very valuable compass for investors in 2010, particularly when combined with other classic ¨value¨ metrics. In my opinion this is a tool which should be more widely used to cut through the confusion in the current investing environment.

Disclosure: No positions