Peter Mycroft P...'s  Instablog

Seeking Alpha is the place that I have decided to do my Pro-Bono work and I will concentrate most of my writings from now on exclusively on the “Power of Free Cash Flow”.  As part of my giving back something to the field that has been very good to me, I have decided to disclose some of the tools I use to pick winner and more importantly to avoid losers.  The motto that I base all my work on is “Capital Appreciation through Capital Preservation”.  This simply means that I only look for appreciation when I am quite sure that I have my preservation part down or in other words when it is “safe” to enter the markets.  My philosophy is to either go long in equities or to go to cash when nothing is attractive to buy.  I use cash as my hedging tool and do not try to get fancy with options or shorting. 

I also keep very close attention to macro-economic events and pay very close attention to what Warren Buffett is doing and more importantly in what he is saying.  In 2008 when Mr. Buffett said that we were in an “Economic Pearl Harbor”, I went to 100% cash without blinking an eye.  So though my work is, as you will see below, quite quantitative, I never try to “catch a falling knife” or “step in front of a moving train”.  Where there is uncertainty I just stay away (currently health care stocks) and where there is tremendous opportunity, that the market has overlooked, I pounce.  Investing is like life, you want live in the best neighborhoods and drive the best cars and avoid traveling through high crime areas or walking in streets where there is a high probability of getting mugged.  I would rather be by the pool in Palm Springs then in the desert of Iraq, if I have the choice.  The markets operate in the same way.

But with all this data bombarding you every day from multiple sources, how on earth can you figure out what is the right thing to invest in?  The answer is, that it is not easy to do so and that you need to work very hard and more importantly you need the right tools to do so.  The ultimate tool to help the investor is a thing called Free Cash Flow.  If you look at the great investors of the present and past and if you dig deep into how they operate you will always see the words “Free Cash Flow” show up.  Bruce Berkowitz, Warren Buffett and many growth investors have relied on Free Cash Flow as their ultimate tool for decades.

Not to get too technical here but Free Cash Flow = Cash Flow from Operations – Capital Expenditures

There are a few ways to use Free Cash Flow that can help bring it down to an easily understandable level.

One is Price to Free Cash Flow = Market Capitalization/Free Cash Flow

For those interested I did a 58 year backtest of the DJIA from 1950-2007 that will show you how I use it. You can download my backtest by clicking here;

https://mycroftresearch.com/uploads/Backtest_1950-2007_Mycroft_Research_LLC.pdf

Price to free cash flow is a great tool when you are analyzing one stock at a time but when you are analyzing an ETF or in our case the S&P 500 I recommend using thisinstead, which is the inverse of PFCF;

Free Cash Flow Yield = Free Cash Flow/Market Capitalization

Price to free cash flow at times can give you results that can distort results, when analyzing a large group of stocks, as one stock could have a Price to Free Cash flow of 200 and the other could have one of just 3.  So Free Cash Flow Yield is best because it doesn’t give you wild swings in your results and basically tells you how much yield can one get in free cash flow at the stock’s current price and thus everything becomes simple and straightforward. Once you do one stock, then you can do the next 499 and get an accurate view of the index from a totally new angle.

The following is a table where I have analyzed the S&P 500 both from an equal weighted and non-equal weighted point of view.  When analyzing financial stocks, since one cannot get accurate free cash flow comparisons from them I simply used Earnings Yield = Earnings/Market Capitalization or the inverse of the famous PE Ratio.

Before posting the table I will just sum it up and then close.  The average yield from this analysis for the entire S&P 500 Index is 4.39% from an equally weighted point of view and 5.42% from a non equally weighted, so based on this analysis those that say that you should invest in the equally weighted versus non equally weighted (as S&P does it) are wrong by as much as 23% when taken from a relative point of view.

By providing this you now have a benchmark to test your portfolio against. How is your portfolio doing on a FCF yield point of view vs. the S&P 500 Index?

Part #2 of my free cash flow analysis of the S&P 500 will show everyone the power of FROIC. That will be in a separate article coming soon.  Here is the table and enjoy.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: 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.  Please note, investments involve risk and unless otherwise stated, are not guaranteed.  Past performance cannot be used as an indicator to determine future results.  Strategies mentioned may not be suitable for everyone. We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of Peter “Mycroft” Psaras, and should not be construed as personalized investment advice. Information expressed does not take into account your specific situation or objectives, and is not intended as recommendations appropriate for you. Before acting on any information mentioned, it is recommended to seek advice from a qualified tax or investment adviser to determine whether it is suitable for your specific situation.