Rules of the Game: Swimming in Cash

 | Dec 03, 2012 | 11:15 AM EST
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You may have noticed we recently launched the Rules of the Game column.

In college, I watched the old Jean Renoir film, The Rules of the Game, a satire of upper-class French society before World War II. Here's one thing I recall from my college film class: The movie is known for its depth of focus. In other words, a viewer's attention is drawn not only the lead actors in the forefront, but also the background action.

Over the past few years, such "background action" in stocks has attracted more and more of my attention. What do I mean by that? I was initially trained as a growth investor, and for several years I taught seminars on simple methods for identifying hot growth stocks: Chart patterns, moving averages, basic earnings and revenue-growth data.

But my stock-analysis methodologies, while continuing to rely on technicals, also evolved to include a greater number of fundamental indicators.

So this column will feature analysis that goes beyond basic technicals and earnings growth data. I'll also get into some portfolio-construction ideas, such as sector and asset-class diversification. These days, my focus tends to be more on large- and mid-caps, but small-caps won't be left out!

With all that in mind, I wanted to share some ideas from a screen I ran that looked for companies with strong free cash flow. This is a metric I have grown to use more and more, and it's a very simple calculation: Take a company's cash from operations, and subtract capital expenditures. It's a good way of gauging a company's ability to fund projects without them having to leverage up.

I scanned for large- and mid-cap companies that have grown their free cash flow over the past three years. I then overlaid some parameters for price performance to get a more complete picture.

I'll go into some detail about one of those stocks today, and flesh out details about others later this week.

For example, Visa (V) has grown free cash flow for the past four years, with that figure totaling $4.76 per share most recently. That jibes with some of the other fundamental strength evident in this stock. For instance, earnings have grown at rates of 21% or more in every quarter of the past two years. Analysts see per-share income of $7.25 this year, up 17% from 2011 -- and, next year, the company expects earnings of $8.36 per share, a gain of another 15%.

The stock is most definitely extended at this point, having rallied 47% year to date. It rallied to an all-time high of $149.93 Friday, and notched a new closing high, $149.71. That's 6.6% above its 50-day average, and 18.3% above its 200-day. That's a bit frothy -- though, of course, frothy stocks can and do run higher still, frustrating those who wait for a pullback.

However, I always prefer to err on the side of caution. The stock has trended above its five-day exponential line since Nov. 16. A retreat to at least the 15-day line, if not the 50- or 200-day, would make an entry more palatable.

This is a good watch-list candidate for reasons pertaining to its fundamentals and technical -- as well as to its story. Electronic payments are only poised to keep growing globally, and Visa is well-positioned to take advantage of the continued move away from cash and checks.

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