High Free Cash Flow = Bad Investment?

Most of us at The Motley Fool, including me, love free cash flow. But if we take that obsession too far, we'll buy into companies we shouldn't, and miss out on some truly great stocks as well.

Today, I'll show you how to avoid that mistake -- and give you a list of stocks with negative free cash flow that might be poised for greatness.

Good FCF, bad FCF
We love free cash flow for a number of reasons, mainly because it gives us a more realistic view of a company's earning power. Yet as you've probably learned if you've been investing for more than a few days now, nothing is ever simple in the world of stock picking.

Joel Litman, the managing director at Equity Analysis & Strategy, is one of top experts around when it comes to evaluating cash flows. At a recent presentation at Fool HQ, he pointed out that there are times to buy heavily into a company with negative free cash flow. Determining "good negative free cash flow" and "bad negative free cash flow" begins with a look at a company's rate of return alongside its rate of growth.

Big orange
The perfect example is Home Depot. The home improvement retailer absolutely plastered (get it?) the market from 1985 to 2001, yet showed negative free cash flow in all but one of those 16 years.

Home Depot Stock Chart by YCharts

Home Depot's negative free cash flow during this 16-year period was the result of management pouring all its cash back into its high-return business -- and not by any deficiency in the business itself. "As long as that growth in capital will realize returns above the cost of that capital," Litman says, "negative free cash flows can be a great sign for the business."

In 2001, Home Depot finally hammered out positive free cash flow, and has maintained that positivity every year since. And what has the stock price done in that period?

Home Depot Stock Chart by YCharts

While some may question investors' sanity during this run, Litman points out that the market understood the issue very well, namely that the positive free cash flow was the result of management slowing its rate of reinvestment back into the business. This is sometimes accompanied by share buybacks, dividend boosts, and other "good things for investors." However, Litman says, "None of these can be as good for shareholders as massive growth into an incrementally high return business."

If a company you own is transitioning to this stage, you may want to consider that its high-return days are behind it.

The next Home Depot
The natural question, then, is which companies today are exhibiting characteristics similar to Home Depot in the early part of its high-growth, negative-cash-flow phase?

I set up a screen for all companies on U.S. exchanges with a market cap greater than $200 million that:

• Have grown their revenues an average of 25% or more over the past two years.
• Have grown their capital expenditures an average of 25% or more over the past two years.
• Have generated negative free cash flow each of the past two years.

Because we're looking for younger businesses early in their growth cycles, I also limited the results to companies that were founded since 2000. Just 23 pass the screen:

Source: S&P Capital IQ.

We're left with a list of young small-cap companies that are investing heavily back into their high-growth business -- just as Home Depot was doing in 1985.

Of the companies listed here, I'm most intrigued by the following four because they seem most true to the early Home Depot profile:

Zipcar -- Fills a huge need with its car-sharing network in major cities. Its losses are narrowing, while cash from operations is positive and growing quickly.

MAKO Surgical -- Makes a robotic surgical system for knee and hip arthroplasty procedures. While cash losses from operations are diminishing, management expects capital expenditures to keep increasing.

A123 Systems -- Makes rechargeable lithium-ion batteries and battery systems for the transportation industry and electric power grids. Management expects continued negative free cash flow for the foreseeable future as it continues to expand manufacturing.

Seaspan -- Operates a fleet of container ships that it charters to large shipping clients on long-term, fixed-rate contracts. It has added 14 ships over the past year or so, and intends to "significantly expand" the fleet in the coming years.

I'll personally be digging deeper into the businesses of these four in the weeks ahead.

Meanwhile, one negative-free-cash flow company that didn't show up on my screen is interesting for another reason: it's well-positioned to take advantage of the natural gas boom. Find out more in our special free report, "One Stock to Own Before Nat Gas Act 2011 Becomes Law."