Follow Free Cash Flow Not EPS
Summary Momentum in earnings is a simple and effective investment idea. A company’s profitability can be described by EPS and FCFPS. Momentum in FCFPS lets investors select stocks with higher potential return than momentum in EPS. Momentum in earnings is a fairly popular criterion for selecting companies that could potentially be a good investment. The idea behind this is very simple, but also quite sound. Steadily increasing profits over a long period of time indicate that this trend is likely to continue in the future. Moreover, if profits grow at a consistent pace, it is also safe to also assume that the company will be doing well in the future. When investors talk about momentum in earnings, they are usually referring to EPS momentum – that is, companies that have a steadily increasing EPS over a long period of time. But another indicator that investors should pay attention to is Free Cash Flow per Share (FCFPS). The thing is that Free Cash Flow is seen by many investors as a metric that reflects real company profits more accurately than Net Income. This, first and foremost, is due to the difference in the way CAPEX is factored into these two indicators. We will try to figure out which momentum in which factor EPS or FCFPS lets investors select companies with the highest potential return. In order to do this, we are going to look at two portfolios. One will be based on EPS and the other on FCFPS. We are going to look at 1,500 largest US companies traded on the US stock exchange from 01/01/2008 until the present. We are going to look at EPS and FCFPS growth over the past twenty quarters (five years). The indicators are TTM. This way, we are going to get YoY EPS and FCFPS growth for every quarter. For the first portfolio, we want to select companies with stable EPS growth. Thus, we are going to select companies that post EPS growth at least 17 times over the past 20 quarters. We will accept that a company can post EPS losses no more than three times, since profit is an indicator that can be affected by temporary negative factors, which will not necessarily be reflected in future earnings growth dynamics. For the second portfolio, we are interested in companies with stable FCFPS growth. We are going to select companies that have posted FCFPS growth for at least 14 out of the past 20 quarters. The reasoning behind this is similar to the EPS-based portfolios, but the requirements are less strict because Free Cash Flow is by nature a lot more volatile than Net Income – it is directly affected by CAPEX and Working Capital changes, which are smoothed in Net Income. We are not interested in companies that posted drops in EPS and FCFPS over the given time period. In spite of the strict criteria outlined above, this is still possible if a company’s EPS and FCFPS decreased so much during a particular quarter that it was unable to recover afterward. Moreover, in order to make sure that the growth trend is not over, one of our criteria is going to be that the current EPS and FCFPS values are the highest for the given period. A lot of companies will match the criteria we have outlined. We need to focus on those who have posted the most stable EPS and FCFPS growth. In order to measure stability, we can use the EPS Growth Sharpe Ratio and FCFPS Growth Sharpe Ratio – the higher these values are, the more stable growth in EPS and FCFPS is for a given company. EPS Growth Sharpe Ratio is calculated as the ratio of average EPS growth for a given period (20 quarters) and the standard deviation of this growth. The Sharpe Ratio for FCFPS is calculated in the same way. In order to make sure that our portfolio contains securities that are posting consistent growth, we are going to select the top 40 securities by EPS Growth Sharpe Ratio and FCFPS Growth Sharpe Ratio that have made it through the previous filters. The market usually recognizes and values companies that post stable EPS or FCFPS growth over a long period of time. This is why these companies can rarely be purchased at an attractive price in terms of Valuation. Since our goal entails not only selecting stocks according to EPS or FCFPS momentum, but also evaluating which indicator can bring in more profits, we need to select securities that are moderately priced relative to EPS and FCFPS respectively. In the first portfolio, we will leave only securities with a maximum P/E ratio value of 25. In the second portfolio, we will leave securities with a maximum P/FCFPS ratio value of 25. Thus, we are getting rid of securities that are obviously overvalued. We are looking at quarterly data, so it would make sense for us to rebalance our portfolios every quarter in order to have the most relevant selection of securities. The graph below shows the comparison between the two portfolios we have described. (click to enlarge) FCFPS Portfolio performs way better than EPS Portfolio. Only in 2011 EPS Portfolio had higher return than FCFPS Portfolio. This result confirms that momentum in FCFPS is more prominent driver of stock returns than momentum in EPS. We already mentioned the possible explanation to such a result. Free Cash Flow reflects cash that was generated by the company in the recent period, whereas Net Income doesn’t include present investments but include past investments as Depreciation and Amortization. Current list of stocks in FCFPS Portfolio is the following. Apple Inc. (NASDAQ: AAPL ), AutoZone (NYSE: AZO ), CB Richard Ellis Group (NYSE: CBG ), Deluxe Corporation (NYSE: DLX ), F5 Networks (NASDAQ: FFIV ), Jazz Pharmaceuticals (NASDAQ: JAZZ ), Jack Henry & Associates (NASDAQ: JKHY ), Kennametal Inc. (NYSE: KMT ), Mednax (NYSE: MD ), The Middley Corporation (NASDAQ: MIDD ), Mettler Toledo International Inc. (NYSE: MTD ), NeuStar (NYSE: NSR ), Priceline Group Inc. (NASDAQ: PCLN ), Red Hat Inc. (NYSE: RHT ), Roper Technologies (NYSE: ROP ), Sirius XM Holdings Inc. (NASDAQ: SIRI ), Scripps Networks Interactive (NYSE: SNI ), SolarWinds (NYSE: SWI ), Universal Health Services Inc. (NYSE: UHS ), USANA Health Sciences Inc. (NYSE: USNA ), United Therapeutics Corporation (NASDAQ: UTHR ). Current list of stocks in EPS Portfolio is the following. Ametek Inc. (NYSE: AME ), AutoNation Inc. (NYSE: AN ), AutoZone , Biogen Inc. (NASDAQ: BIIB ), The Walt Disney Company (NYSE: DIS ), Fastenal Company (NASDAQ: FAST ), Home Depot (NYSE: HD ), Henry Schein (NASDAQ: HSIC ), J. B. Hunt Transport Services (NASDAQ: JBHT ), LKQ Corporation (NASDAQ: LKQ ), Mednax , 3M Company (NYSE: MMM ), Mettler Toledo International Inc. , Old Dominion Freight Line (NASDAQ: ODFL ), Omnicom Group Inc. (NYSE: OMC ), Penske Automotive Group (NYSE: PAG ), Paychex (NASDAQ: PAYX ), Polaris Industries Inc. (NYSE: PII ), Portfolio Recovery Associates (NASDAQ: PRAA ), Robert Half International Inc. (NYSE: RHI ), Roper Technologies , Ross Stores (NASDAQ: ROST ), Signature Bank (NASDAQ: SBNY ), Snap-On Inc. (NYSE: SNA ), T. Rowe Price Group (NASDAQ: TROW ), Wabtec Corporate (NYSE: WAB ), Whole Foods Market (NASDAQ: WFM ). It is noteworthy that some stocks are present both in FCFPS and EPS Portfolios. These are AZO, MD, MTD and ROP. These companies had the most consistent growth both of EPS and FCFPS. Conclusion. Momentum in earnings is a simple and effective investment idea. Companies that posted profit increases in the past have good potential for growth in the future. A company’s profitability can be described by EPS and FCFPS. The test we conducted shows that the combination of a steadily growing FCFPS and moderate Valuation by P/FCFPS allows is to select securities with higher potential profitability than the combination of a steadily growing EPS and moderate Valuation by P/E.