This article is part of our Rising Star Portfolios series.
Let's say you've found a company that, after years of negative free cash flow, has finally turned positive. Is it time to buy?
Perhaps. But it may also be a huge mistake.
It all depends on why the business is flipping from negative to positive free cash flow, and whether the market properly understands the situation.
Sometimes companies with negative free cash flow are great buys. My "Next Home Depot" screen is designed to find such businesses -- ones that exhibit the same traits as Home Depot in the mid '80s before it exploded for 1,500% gains over the next 15 years.
As I explain in this article, the market understood that Big Orange was exhibiting negative free cash flow only because it was reinvesting its free cash heavily into its high-growth business. By 2001, that high growth was done, Home Depot's capital expenditures subsided, and the business turned free-cash-flow positive. Not coincidentally, the stock price ceased its upward surge, and has been relatively flat since then.
If a company you own is transitioning to this stage in this same manner, you may want to consider that its high-return days are behind it. I recently constructed a screen to see if I can identify such businesses.
For this screen, I looked for the following:
- Two years of positive free cash flow, after at least two years of negative FCF
- Two years of capital expenditure growth slowing to less than 20% annually, after two years of 20% or greater growth
- A similar slowdown in revenue growth
I isolated only the two years prior to the first FCF-positive year because even Home Depot snuck a positive year into its 15-year run. I just didn't want an occasional anomaly in any of these metrics to eliminate a company that otherwise fits what we're looking for.
Five to chew on
Only five companies passed this screen, and I can't really say any of them are reminiscent of the Home Depot situation. For instance, O'Reilly Automotive
Not good enough
I had thoughts of this becoming an official screen for my Rising Star portfolio, the perfect complement to my Next Home Depot screen -- but I don't think it's ready for prime time. I don't feel I captured companies that are in the same position Home Depot was in the early 2000s. I'll continue my research and perhaps refine things a bit, and we'll see where the future takes us.
Fool analyst Rex Moore says if you're not failing, you're not trying. He owns no companies mentioned here. Motley Fool newsletter services have recommended buying shares of Home Depot. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.