In this space, we spend a lot of time writing about how to invest in small-cap growth companies. But you should know that the Small Cap Foolish 8 strategy is just one way of investing in small capitalization companies. For one thing, the Foolish 8 criteria are so heavily weighted towards growth in sales and earnings that only the very fast-growing companies with a lot of stock price momentum will ever make the list.
This tends to make the stocks somewhat risky, but then again, the Foolish 8 is designed to try to find companies with clear momentum -- these are the types of companies that can go up five or tenfold in a year or two if everything breaks just right. If you are lucky enough to find one of those every couple of years, it makes up for a lot of dogs.
Perhaps like many of you, however, I find myself less inclined to run such a high-risk portfolio these days. Oh, I still look for (and occasionally find) high-growth small companies that I think are worth taking a position in. But I have also found that investing in small-cap companies that don't feature the eye-popping growth but that do generate a lot of cash and grow that cash flow consistently often sell for much more reasonable prices than their high-flying counterparts. It's also my conviction that these companies offer much less risk, both in terms of the risk of overpaying for the stock and operationally. Even better, if you pay a low multiple to that cash flow, you're going to have a good chance of getting a decent return on your investment.
It's important to remember that when discussing cash flow, I'm talking about free cash flow -- that's the cash from operations minus any capital expenditures that the company needs to make to maintain and grow their businesses. This information is found on the statement of cash flows, which most companies still don't put on their quarterly press releases, but which you can find in their quarterly 10-Q filings, and which are also now available in the company profile on Yahoo! Finance.
The operating cash flow can be found in the total labeled as "cash from operating activities." The capital expenditures can be found under "investing activities," and will usually be labeled as "additions to property and equipment" if the term capital expenditures is not used. Just subtract the capital expenditures from operating cash flow, and you've got free cash flow. You'll want to check cash flow for the last couple of years to make sure that the most recent reporting period is representative of the company's true cash-generating capability.
Cash-on-cash returns
Say you find a company with a market cap of around $100 million. If you look at that company's cash flow statement, and you find that it is generating $10 million a year in free cash flow, then the cash return on that investment is 10%. Now, 10% is probably the minimum that you would expect from your stock market investments over time, so that's a pretty good place to start.
If you can find a company that consistently generates free cash of $10 million and only has a market cap of $50 million, that's a 20% cash-on-cash return. Of course, companies that are growing rapidly probably won't be selling for 10 times free cash flow, while companies that aren't growing at all may sell for less. The best deal of all is when you come across a company that a) generates a lot of free cash flow, b) is growing that cash flow at a reasonable rate, and c) is available at less than 10 times annual free cash flow.
Also, you have to remember that unless the company pays out all that cash flow to investors in the form of a dividend, you the investor aren't going to see the cash directly. However, if the company's management has any ability at all, they will be able to use that cash to increase the value of the business or pass that cash through to you by making small acquisitions, paying dividends, buying back stock, or expanding geographically.
Mission impossible?
Sounds impossible, huh? Such bargains don't exist, right? Well, I think you'd be amazed at how often such stocks pop up. The problem is that most of the time the companies will be very small -- most likely in the sub- $150 million market cap range.
This is true because a company with that kind of cash flow at such a bargain price wouldn't be able to escape the eyes of institutional investors for long, and therefore the price will be bid up very quickly once discovered. But just as the best fast-growing small caps are purchased at low daily dollar volume levels, which makes them too illiquid for all but the smallest institutional players, the best bargains in small-cap cash flow generators are going to be in the smaller market cap ranges.
The risk of small companies
Most of us just assume that a small company is a riskier investment than a large company. Intuitively, it just seems like it would be easier for a tiny company to run into problems and go under than it would for a larger one. There is some truth to this; I personally believe that smaller companies have higher business risk than most larger companies.
The beauty of buying cash flow is that it is very difficult for a company to totally implode if there is more cash coming in than going out. If there is a lot of cash coming in, then even the poorest management almost can't help but figure out some way to increase the value of the business. Even if they use a lot of it to give themselves big raises, throw lavish parties, and commission oil portraits of themselves for the company boardroom, they will usually at least raise the dividend a bit or buy back some shares to keep shareholders off their backs. If company management owns a decent percentage of the company stock, then chances are even better that the cash flow will find itself coming back to shareholders in one form or another.
In short, buying cash flow at good prices by finding small-cap companies that trade at 10 times their demonstrated cash flow generation will diversify and most likely lower the risk of your small company portfolio.
