Peter Mycroft Psaras'  Instablog

The following is a lesson in free cash flow analysis and portfolio construction for the long term investor.  The market has had some seriously wild swings in the last 365 days and can drive anyone crazy (who watches it every day and who does not understand how it works).  Basically the investment process is based on two streets. One is Wall Street and the other is Main Street.  99% of my analysis work is based on Main Street as that is where the actual companies I analyze do business.  Wall Street, on the other hand is just 1% of my work as I only go there to get the quotations that to tell me what the market thinks the companies I analyze are worth.  Wall Street is an extremely dangerous place if you don't know what you are doing.  Part of my job as a fiduciary is to teach my clients how it all works, so that they can sleep well at night and not be upset when we have short term downturns and not get overexcited when we have large upswings. 

 Because many Wall Street participants don't know the difference between a cooking sheet and a balance sheet, they base the majority of their investment decisions purely on emotion.  This is extremely dangerous behavior and is the reason for the panics on the upside and downside that is the history of the stock market.  Because market participants are basing their decisions on emotion, the markets swing back and forth and have good days and bad days, super weeks and terrible weeks, super years and terrible years. 

 Imagine going to the supermarket and not having a list of things you need and basing your decisions purely on emotion and quick gratification.  Basically you would end up eating pizza, french fries and ice cream at every meal.  But you know better than that, because you understand that if you eat those foods at every meal you will not last very long, as reality will hit you real fast with massive hospital bills for heart disease and obesity.  Unfortunately the same thing can happen to you in the stock market if you don't know what you are doing and though you may enjoy a great run for a few years and make tons of money betting wildly, you will eventually have years like 1973, 1987, 2001 and 2008 and have 50%+ of your nest egg wiped out.   

 Reality shows us that if you don't know what you are doing that you can lose as much as you win, so if you are a short term investor or even worse a day trader, you are basically gambling.  Having said that, then how do investors like Warren Buffett average 20%+ average annual gains for 50 years and turn $100,000 into $40 Billion?  The reason is because they concentrate all their analysis on Main Street and only go to Wall Street 1% of the time when they just need a quote, just like when you only go to the supermarket, when you know what you want to buy.  They wait for things to go on sale, before they buy them, and know the quality of what they are buying before they even enter a trade. 

 To show you the difference between Main Street and Wall Street let’s look at a company called Accenture (ACN). On Wall Street the stock price, though volatile, was trading at a high in 2001 of $28 and currently sells for $39.12.  On Wall Street you can see that the stock has not done much, being up only 39.71% in the last 8 years.  On Main Street though we have a different picture based on reality.  During the last 8 years Accenture’s free cash flow per share went from $.62 in 2001 to $4.08 today. That's a gain of 558% or an annualized return of 26.55% per year.  Then if that's the case then why didn't the stock go up as much?  Very simply, the stock in 2001 was extremely overvalued and now it is extremely undervalued.  The company has been a killer on Main Street for years, but since everyone overpaid so much for it in 2001, buying it at 58 times its free cash flow per share (similar to buying a Toyota Prius for $300,000), it took its Main Street numbers 8 years to catch up to the Wall Street price.   

Your average shopper in the supermarket knows that when their favorite toothpaste goes on sale for 50% off, they back up the truck and buy 5 tubes.  They unfortunately do the exact opposite in the stock market and usually buy their favorite stocks at multiples many times what a professional analyst would.  I say analyst because most advisors and stockbrokers are in the same boat as the average investor and have no clue what they are putting their client’s money in as they are simply salespersons. 

 I have spent the last 35 years formulating my system to make it as simple as possible for the average investor to understand.

Basically my rankings are so;

Price to Free Cash Flow of;

30+ = Sell

15.01-29.99 = Hold

10-15 = Buy

8-9 = Strong Buy

7.99 or less Ultimate Strong Buy

I basically use those numbers above for the long term, but sometimes  need to sell when the qualitative news on a company is bad, Like Apollo Group (APOL) and ITT Educational (ESI) going before a congressional committee for possible price fixing or MasterCard (MA) possibly having the way they do business altered by Congress.   Though all three are great companies, their Achilles heel is that they are at the mercy of Congress and one wrong decision by Congress and their stocks tank losing 20-30% in a week. 

 People always ask me, why do I think Microsoft(MSFT) is oversold, since it has been a dead stock for the last decade on Wall Street.  The answer is very simple.  In 1999 when the stock was trading at $60 a share it had a free cash flow per share of $0.78 and was trading at a price to free cash flow of 76.92 (extreme sell).  Right now the company has a free cash flow per share of $1.80 and trades at 13.87 times its free cash flow.  So had you followed my system you would not have owned Microsoft in 1999 and would have avoided losing 67% of your money when it crashed the following year and went down to $20 a share.  Business has been great at Microsoft on Main Street but on Wall Street it was a big loser.  On the Qualitative side it should be a big winner in the near future because Windows 7 is coming out in a couple of weeks and with over 1 billion+ personal computers in the world using Microsoft's operating system it should do very well indeed.  When I tell that to people they tell me, but why shouldn't I buy Apple instead?  Very simply Apple (AAPL) though a great company on Main Street is selling for 31 times its price to free cash flow and is overvalued.  An analyst recently gave Apple an upgrade and set its price target at $280. At that price it would trade at 48 times its free cash flow.  It might hit that price, but if he is wrong, the stock could go down 50%.  It would be much smarter and safer to be in MSFT than AAPL simply because one is oversold and one is overbought.  One of the most dangerous things you can do in investing is fall in love with a stock and that is what has happened with many Apple shareholders.

In conclusion I believe in diversifying into a portfolio of 20-30 well researched companies. These companies should not be bought for having just one good year, but should have consistently put up great numbers over the last decade.  My portfolio construction consists of putting my clients in a portfolio, currently 29 stocks, where they as a group are selling at a price to free cash flow of  12,74 and a free cash flow return on invested capital of 20%+.  It also doesn’t hurt that they also pay a 3.12% group dividend to boot.  Investing and proper portfolio construction is not difficult if you concentrate your attention on price to free cash flow.  It is God’s gift to the Analyst.

Disclosure; Long MSFT, ACN No Position; AAPL, ESI, MA,APOL

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 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.