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.

Today, I'll show you how to avoid that mistake -- and I'll 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 it 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 31 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 might be investing heavily back into their high-growth businesses -- just as Home Depot was doing in 1985.

Today I'll look at some companies that have struggled in recent months. Mako Surgical has had a very tough time of it after cutting guidance twice in two months. It's now off 70% from its 52-week high and 67% on my screen's scorecard. There's still a lot of promise in the robotic RIO system, but fellow Fool Rich Duprey wants management to curb its enthusiasm.

Uncertainty continues to mess with Molycorp. The stock recently hit a 52-week low in the wake of plummeting rare-earth-mineral prices. There's no telling when the tide will turn, and I won't consider Molycorp for my portfolio until the picture clears up.

Clean Energy Fuels has also struggled, but to a much lesser degree. The lower price provides a good entry point for a company ready to reap the rewards as more natural gas vehicles hit the road. Meanwhile Heckmann, which provides water and wastewater solutions for the fracking process, could be hurt by the drought hitting much of the U.S.

A123 Systems (Nasdaq: AONE) dropped off the screen this month, but not before a curious drop of 20% on Friday. The stock plummeted after the battery-maker announced Qualcomm CEO Paul Jacobs left its board of directors. Jacobs says he resigned in order to focus on Qualcomm's "growing and increasingly diverse business." That in itself shouldn't move the stock significantly, but the market is clearly reading more into this.

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.

While Clean Energy Fuels is a risky play in the energy sector, there's a far more stable stock out there that should benefit no matter which way the energy winds blow. Find out more in our special report, "The Only Energy Stock You'll Ever Need." It's free for the taking.