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How to invest in the wake of the stock market rout

Brian Sozzi
Editor-at-Large

Now that the roaring bull market in stocks has effectively dropped dead, it’s almost time to go hunting for long-term investments that can be had on the cheap.

The sticking point though is that any stock being bought should reflect an underlying company with a ton of cash. More specifically, loads of free cash flow — which for investing newbies out there is cash flow from operations minus capital expenditures.

These are often fundamentally solid companies that have managers not going too crazy spending on risky longer-term investments. That’s a critical factor ahead of a year like 2019 that may bring slowing global economic growth and rising interest rates, which could be a setup for companies earning weaker returns on long-term investments. By having more free cash flow on hand, a company could move quicker in volatile markets to buy back stock on the cheap, acquire other companies at a discount or raise dividend payouts.

“We would avoid companies with increasing capex (Facebook, Amazon, Netflix, Google), high labor intensity (discretionary, other services industries) and leverage, all of which represent claims against cash. R&D is the only cash burn we like, as it has been a good signal of superior returns and long-term growth,” suggests Bank of America Merrill Lynch strategist Savita Subramanian. “Low price/earnings [ratios] tends to work during early cycle markets, then low price/sales [ratios] tends to work as top line picks up during mid-cycle. But later in the cycle, as capex and inflation begin to weigh on profitability, free cash flow based factors offer the best relative returns.”

What names screen well?

Finding worthy companies with strong free cash flow isn’t as daunting as it sounds. By using the Yahoo Finance stock screening tool — inputing large-cap companies with PE ratios under 20 and free cash flow over $500 million generated in the last 12 months — we uncovered 138 potentially lucrative opportunities.

From there, we singled out three companies that on paper look fundamentally OK.

They include:

PayPal: The mobile payments giant has racked up $3.8 billion in free cash flow year-to-date due to strong sales and earnings. In turn, Paypal (PYPL) has spent billions this year on acquiring other companies. Having just talked with PayPal CEO Dan Schulman on a panel discussion at the Museum of American Finance, it’s likely buying other companies will remain a focus moving forward. Schulman says PayPal looks at 250 companies a quarter for potential acquisitions or partnerships.

TJX Companies: The off-price retailer has pulled in $1.6 billion in free cash flow year-to-date as a healthy U.S. economy sent shoppers to the stores. Third quarter same-store sales rose an impressive 7%. TJX (TJX) has spent a decent chunk — $1.5 billion — of its free cash flow to buy back stock this year.

Bristol Myers Squibb: The pharma company’s free cash flow has tallied $2.8 billion year-to-date. With the company’s most recent earnings surging 45% from last year, it’s no wonder cash flow has been so strong. Bristol (BMY) has spent close to $2 billion on stock buybacks this year.

By no means is this a fool proof way to find the best stocks, especially in the currently volatile market backdrop. After all, Apple (AAPL) generated $77 billion in free cash flow for the 12 months ended Sept. 29. But, Apple’s stock has tanked 19% in the past month on growing fears of slowing iPhone demand. It’s also vital to remember market sentiment (which is presently going against Apple and others in big tech) among other measures key in selecting stocks.

Happy shopping.

Brian Sozzi is an editor-at-large at Yahoo Finance. Follow him on Twitter @BrianSozzi

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