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, EquitiesLab (183 clicks)
Research analyst, long/short equity, deep value, growth
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Summary

  • Screening strategies that require great free cash flow leads to outperformance in bullish years and limits draw downs in bearish years.
  • The Free Cash Flow Growth strategy is comprised of purely fundamental data and has significantly and consistently outperformed the market in the past.
  • Stocks that currently pass include Activison Inc (ATVI), VMware Inc (VMW), Sony Corp (SNE), and others.

Through research we have noticed that screening for criteria that deal with a company's free cash flow makes a very positive impact on back test performance. Not only does it lead to outperformance in bullish years but it also limits draw downs in bearish years. In Equities Lab we created a strategy almost completely comprised of conditions that deal with a company's free cash flow, and it has been validated to significantly outperform the market in the past. In this article we will provide as much transparency as possible on the strategy then present you with the passing stocks.

The Screening Criteria:

Below you will find a screenshot of the conditions that a stock must meet to make it to the results:

(click to enlarge)

The conditions from top to bottom state the following:

- Market cap greater than $250 million.

- Cannot be a financial stock.

- Free Cash Flow to Shares from the most recent reported year must be at least 10% greater than the previous reported year.

- Free Cash Flow to Shares from the most recent reported quarter must be at least 10% greater than the same quarter the previous year.

- Free Cash Flow to Shares from 2 quarters must be at least 10% greater than the same quarter the previous year.

- The stock's valuation based on Price to Free Cash Flow must be at least 15% greater than the most recent closing price.

- Free cash flow for the most recent reported year, most recent reported quarter, and the previous quarter must all be greater than 0.

- Price to Free Cash Flow per Share must rank in the bottom 35% of the Industry.

The result of the conditions above is usually around 15-20 stocks, but notice the 2 tabs in the screenshot above labeled "max_holdings" and "order_by". In the order_by tab you will find cash_to_shares_1Q and in the max_holdings tab you will find 10. So of the 15-20 passing stocks, only 10 are allowed to show up and the 10 we choose have the highest cash to shares.

Backtest Performance

By default the backtest computes performance based on a weekly rebalance, so the only time trades are made are on the first trading day of the week. It buys the stocks that pass the strategy then holds them until the next rebalance day; if the stock still passes after one week then we continue to hold, if it no longer passes then we sell it and new stocks that pass the strategy are bought. We then plot the portfolio performance on a graph next to the S&P 500 and Russell 2000. Below is the backtest result of the strategy described above:

(click to enlarge)

The total return of the strategy from January 3, 2003 to June 16, 2014 is 1717%, or a 28.61% annualized return. 1,878 trades were made during the back test representing about 14 per month. The image below displays the year by year breakdown of the performance:

(click to enlarge)

The strategy outperforms the S&P 500 in all 12 years the backtest covers. In 2014, the strategy has already returned 12.7% while the S&P 500 is up around 6%, and in 2008 the strategy only lost 22% while the S&P 500 lost over 35%. The pie graphs below will give you an idea of the sector and size of the companies included in the backtest.

(click to enlarge)

A little under one half (419 of 943) of the total positions were small cap (between $250 million and $2 billion). Of those positions, the average return was 2.9%. 278 of 943 (29%) were mid cap with an average return of 4.2%. 194 (21%) of the positions were large cap and had an average return of 3.2%. Mega cap stocks represented 52 (6%) of the positions and had an average return of .96%. In terms of sector, technology and health care and services and basic materials combined to represent with the majority of the positions.

In order to ensure a strategy is worth trading we test multiple rebalance periods and trading costs. The graph below represents a monthly rebalance and a .2% trading cost per trade:

(click to enlarge)

A monthly rebalance with a .2% trading cost per trade gives a total return of 1052%, or 24% annualized. The total amount of trades is 997 which comes out to 7 per month.

Passing Stocks

(click to enlarge)

The heat map above displays the stocks that currently pass the strategy and are colored based on their price change over the past month.

Company

Industry

Equities Lab Value Score (Out of 10)

Income Statement Score

Cash Flow Score

VMware Inc (NYSE:VMW)

Software & Programming

6 - Good

8 - Great

8 - Great

Corning Inc (NYSE:GLW)

Electronic Instruments & Controls

7 - Good

5 - Decent

6 - Good

Sony Corporation (NYSE:SNE)

Audio & Video Equipment

8 - Great

2- Bad

10 - Amazing

Citrix Systems Inc (NASDAQ:CTXS)

Software & Programming

6 - Good

3 - Bad

9 - Great

Activision Inc (NASDAQ:ATVI)

Software & Programming

7 - Good

7 - Good

8 - Great

Herbalife Ltd (NYSE:HLF)

Personal & Household Products

7 - Good

4 - Decent

9 - Great

UniFirst Corp (NYSE:UNF)

Business Services

5 - Decent

6 - Good

8 - Great

Web.com Group Inc (NASDAQ:WWWW)

Technology

3 - Bad

10 - Amazing

8 - Great

Strayer Education (NASDAQ:STRA)

Schools

5 - Decent

0 - Awful

10 - Amazing

Kimball International Inc (NASDAQ:KBALB)

Semiconductors

8 - Great

7 - Good

8 - Great

If you would like to know the backtest performance with specific trading costs or rebalance intervals then let me know and I can provide the answer in the comment section.

Source: Free Cash Flow Growth Leaders Worth Looking At