The first lessons most individual investors learn about the stock market are to look for stocks with low price-to-earnings (P/E) ratios and high dividends. These data points are even readily available in many newspapers. Unfortunately, they do not provide enough information to deliver investment success.
Value stocks might offer low P/E ratios and high dividends, just like a stock headed for trouble might.
To avoid the problem socks, many professional investors look at cash flow in addition to looking at earnings. Earnings are reported under complicated accounting rules and could rise even as the company is experiencing problems. Cash flow measures the amount of dollars (or other currencies) that a business generates as revenue and uses to pay its bills. It is measured in real-time, unlike earnings, which are reported based on when revenue and expenses accrue to the business.
Citibank (NYSE: C) offers an example of how earnings and dividends can be deceptive, while cash flow reveals the true state of the company.
In 2007, Citigroup reported earnings per share of $6.77 and paid $2.16 in dividends. The stock price was falling that year and ended at $28.80. Investors looking at the P/E ratio of 4 and dividend yield of 7.5% might have thought they spotted a value stock.
But investors who looked at cash flow would have seen that cash flow from operations had been negative in 2006 and 2007, a sign that Citigroup was facing problems.
The dividend was cut in 2008, and in 2009, the stock would trade under $1 before a reverse stock split was used to push the price back above $5.
In addition to these examples, there are a number of studies that show the value of cash flow. In Quantitative Strategies for Achieving Alpha, Richard Tortoriello showed that cash flow is a predictive variable, meaning that strong cash flow is seen in companies before the stock price goes up. Earnings and dividends are not as useful for identifying future winners.
We can also look to the world's greatest investor for proof that cash flow is important. Warren Buffett relies on cash flow more than earnings to find great stocks.
We don't know exactly what Buffett looks at, but he has written in an annual report that he evaluates owner's earnings -- a metric he defines in terms that are similar to what accountants would call cash flow. Owner's earnings are found by adding non-cash accounting charges to reported earnings and subtracting the amount of money needed to maintain the business' operations. Buffett's genius lies partly in defining which costs to add and subtract from the reported earnings.
I understand that there is only one Warren Buffett, and it seems unlikely that anyone will ever duplicate his success. But I can build a model to approximate his way of thinking.
Cash flow from operations can be found in a company's financial statements. Tortoriello and others have found that growth in cash flow often precedes growth in the stock price. Growth in cash flow can be found for each publicly traded company and the values can be ranked. Investors should focus on the companies with the strongest growth in cash flow.
One problem with all value investment strategies is that they require patience and patience can remain unrewarded for years. Rather than finding value stocks and hoping other investors agree with my judgment, I look for value stocks with high relative strength (RS). When RS is high, it means other investors are buying and the value is being recognized.
I used these two factors to develop a trading system. Right now, two relatively unknown companies with strong gains in cash flow and high RS are strong buys. Analysts expect strong earnings growth from both Himax Technologies (HIMX) and Capital Senior Living (CSU), and the stocks could continue to rise if the companies meet expectations. Because cash flow can be used to predict strong gains, these companies should meet expectations and deliver investment gains.
Consider buying HIMX and CSU. These would be long-term positions which should be held until RS or growth in cash flow weakens.