In Praise of Free Cash Flow

 | Aug 27, 2014 | 3:00 PM EDT
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I am something of a nerd, so if you don't have healthy interest in books, baseball or stocks, most conversations around Chez Melvin could lead to death by disinterest. Last night, was no exception as I spent several hours chatting about valuation ratios while watching the Orioles add a game to their lead in the AL East. My preferred metric for picking cheap stocks always has been and always will be price-to-book value, but I know that others prefer different methods. As I wrote yesterday, Tobias Carlisle has written a new book where he talks at length about the EV/EBITDA ratio. And I have friends who are very successful value investors who use price to free cash flow.

I haven't run a price-to-free-cash-flow screen in a few weeks and have not written about this approach to value investing in some time. So I launched a search for companies trading in the bottom 10% of all companies ranked by this metric. Some interesting names made the grade and are worth additional research and consideration for long-term investors.

Harbinger Group (HRG) is a conglomeration of companies run by hedge fund manager Phillip Falcone. While Falcone has had his problems with the SEC and his hedge fund operation, he has built a great mix of businesses at Harbinger and it produces massive amounts of free cash flow. It is in the consumer products business via its position in Spectrum Brands (SPB), which sells things like batteries, pet supplies, small appliances, grooming and shaving supplies, and bug spray through popular brands that include Rayovac, Remington, George Foreman, Farberware, Hot Shot and Black Flag. Harbinger also has interests in oil and gas, insurance, reinsurance and lending. It has caught the eye of a t least one savvy investor as Leucadia (LUK) is the largest shareholder. At a multiple of just 4.2x, the stock is very cheap on a price-to-free-cash-flow basis.

Engility Holdings (EGL) provides what it calls a "lifecycle of capabilities that aligns with the critical priorities of the U.S. Government, both domestically and globally." It offers consulting services for the feds that include issues such as climate change, air traffic management, emergency preparedness and response, and health care IT. It also offers logistic management, IT services and education support to various government agencies. While the federal government talks a lot about cutting back, there is still a lot of business passed out each year, and Engility is getting its share, plus a little extra. It generates a lot of free cash flow and trades at just 4.1x the cash generated at the current price. The price-to-book-value ratio is not outrageous at 1.4, and the stock could be become very attractive when the market pulls back a bit.

Global Cash Access Holdings (GCA) has carved out a niche in financial services. It provides services that allow casino patrons to get more cash through a variety of methods, including ATMs, cash withdrawals, credit card cash access transactions, debit card transactions and check verification. It also provides services that help casinos with credit decision-making, automated cashier operations and marketing. As states have begun to allow more online gambling and poker, the company has expanded into online payment processing. Global Cash has operations in all the major gaming markets, including the U.S., Europe, Canada, the Caribbean, Central America and Asia. This specialized profitable niche of gaming markets allows the company to generate substantial free cash flow, and the stock is cheap at an FCF multiple of just 4x.

While I prefer price to book value as the major determinate in evaluating stocks, there is more than one way to skin the value cat. Companies that generate high levels of free cash flow will be able to pay down debt, buy back stock and increase shareholder dividends. They can use the cash to expand business or make acquisitions that increase the value of the company. All of these can be factors in pushing the stock price much higher over time.

Looking beyond just one metric can help uncover stocks that might be overlooked with more limited research screening.

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