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 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.
Four on the floor
Four companies passed this month: O'Reilly Automotive
I mentioned in the last article that I felt the screen was having a hard time finding companies that are in the same position Home Depot was in the early 2000s. For example, O'Reilly had several FCF-positive years in the past, while the metrics have been all over the place for Air Methods, Hallador, and NetSuite in past years.
RTI Biologics actually dramatically increased its capital expenditures in the past 12 months. And MetroPCS, which seemed the best fit from last month, dropped off the screen and is up 36% since my article published.
In short, none of these companies fits the bill.
There are a couple of possible reasons why the screen is not pinpointing what I want. The criteria I'm using may not be suitable, for example. Or, no matter how good the criteria, it's likely that in any given month there just aren't going to be a lot of companies transitioning from hyper to slow growth.
I think the criteria are fine for identifying companies that have slowed down revenue and capital spending growth, but next month I might try tweaking these variables a bit.