Positive Signs for These Negative Cash Flow Stocks

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.

Today, I'll show you how to avoid that mistake -- and give you my monthly 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, nothing is ever simple in the world of stock picking.

Joel Litman, managing director at Equity Analysis & Strategy, is one of the 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 the market from 1985 to 2001, yet showed negative free cash flow in all but one of those 16 years.

Home Depot's negative free cash flow during that period was the result of management pouring all its cash back into its high-return business -- and not because of 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. Its stock price, however, has been relatively flat.

Litman says the market has 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, he 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.
• Grown their capital expenditures an average of 25% or more over the past two years.
• 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. A total of 37 pass the screen this month:

Data provided by S&P Capital IQ. TTM = trailing 12 months.

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

There are interesting companies to research here. I already purchased one stock because of this screen: Zipcar.

Looking at a cross-section of other companies, Heckmann is well-known and considered undervalued by some of our Fool advisors. Clean Energy Fuels is the leading provider of alternative fuel for U.S. and Canadian commercial vehicle fleets -- a huge growth area. MAKO Surgical is in another high-growth field: robotic surgical systems. Cash losses from operations are diminishing, and management expects capital expenditures to keep increasing.

Chinese e-tailer DangDang, meanwhile, has great potential, but faces some serious competition. Add the fact that it's a Chinese small cap, and the risk is pretty high with this one.

Some don't really fit the early Home Depot mold. ExactTarget, for instance, provides marketing software, and its capital expenditure increases aren't quite the same as when Home Depot was ramping up and rolling out stores.

Winners and losers
As is the case with all of my screens, this one is now being tracked and scored so we can measure exactly how it's performing. Check my "Next Home Depot" CAPS page here, and mark it as one of your favorites.

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 "The One Stock You Need to Own for the Coming 'No Choice' Energy Revolution."