Get Rich With Their Cash

What the market wants
You've probably heard this before:

In the short run, the market is a voting machine, and in the long run, it's a weighing machine.

What's it mean? Basically, share prices over the immediate term can whipsaw for umpteen reasons, many of which may have little or nothing to do with a company's true worth.

Over the long run, however, the market does ultimately reward companies that produce profits -- but not just any profits, cash profits. Earnings are no good if a company has to keep plowing all that money back into capital expenditures.

That's why free cash flow (or variants, such as the owner earnings favored by Fool co-founder Tom Gardner and Warren Buffett, among others) are vital to the investing methodology that many of us follow here at the Fool. By taking cash flow from operations, then subtracting capital expenditures, we hope to get a truer picture of a company's real profit potential for you, the investor.

Don't believe that cash matters? Look at this.

Show me the money
I was messing around with some screening tools last weekend, and I decided to see which companies out there have the fattest free cash flow margin -- that is, how much of a company's revenue is turned into cold, hard cash.

Of course, the results can vary from year to year, but to make sure I wasn't just picking up one-year wonders, I added another step to make sure the results included only companies that made a habit of increasing their operating cash flow by more than they increased their capital spending. The only other growth hurdle I set was that earning growth over five years be better than zero.

After coming up with an interesting-looking list, I decided -- just for grins -- to see whether there was any correlation between this cash profitability and shareholder returns.

The results were eye-opening, to say the least.

A full 11 of the 15 returned more than 10% annually. For the whole list, that's an average five-year return of more than 220%, or an average compounded annual growth rate of 23%.

What about the market?
Wonder how that rates against the market as a whole? No contest. The S&P 500's return over the past five years has been tiny -- 9%, or 1.8% per year. Even the worst of these stocks would have served you better than the benchmark index fund. (And if you'd bought two of the list's biggest losers when they bottomed during the past half-decade -- American Eagle and Intuit -- or lightened up on Forest Labs in January 2004, you could have made a killing on all of those, too.)

Foolish bottom line
What are the takeaways here? One is that there seems to be a real sweet spot for small-to-mid-caps. Nearly every one of these companies began its run with a market cap between $500 million and $5 billion. (There were only two on either side of that spread.) That's not much of a surprise to many of us. Small caps are often the market's biggest winners because they're small enough that you can buy before every big fund in town is able to get on board.

But the real key is that free cash flow. It enables companies to pay for growth without debt and reward shareholders with everything from dividends to share buybacks. It's no coincidence that free cash flow and size are two of the primary criteria for finding stocks at Motley Fool Hidden Gems.

By selecting stocks that meet those standards, as well as seeking shareholder-friendly management, Tom Gardner and his guest analysts have beaten the market by 27 percentage points since July 2003. If you want to take a look at companies that have a good shot of making it onto my cash flow screen five years from now, after turning in 20% annual returns, take a look at Hidden Gems. A free 30-day guest pass is available.

Seth Jayson is tweaking his screen to find these monster stocks before they put in 20% annual returns. At the time of publication, he had shares of American Eagle but no position in any other company mentioned here. View his stock holdings and Fool profile here. Intuit is a Motley Fool Inside Value recommendation. Fool rules are here.