MyCortex

Fundamentally, most companies are in much better shape than their stocks indicate.  My belief is that the market has slammed stocks with near-term debt maturities the worst, then stocks with minimal or no cash flow, then stocks that have binary growth trends (i.e. if something works, then great, if something doesn’t, the company goes under).

There are tons of great buys out there, but what do you buy?  In my estimation, there are three factors that will determine the best long-term investments:  ROIC (return on invested capital), NOLs (net operating loss carryforwards), and cash flow.

The third should be obvious.  In times like these, it is entirely plausible to find a stock where the free cash flow of the company (net income - working capital - capital expenditures) can, in a few years, equal out to the entire value of the equity.  These businesses, as long as they aren’t rapidly deteriorating, should be great buyout targets.

ROIC is the measure of cash flow, usually EBITDA - cash taxes paid - capital expenditures, divided by the invested capital base of the company, which is (simplistically) the net asset value.  Think about it…if a company is growing its earnings, but is spending like crazy behind the scenes on capital investment (buildings, equipment, etc) in order to drive that growth, are those earnings worth much?  Now, imagine a company with a large invested capital base, like a telecom or fiber operator.  They now just sit back and rake in the cash that is thrown off from their previous investments.  Depending on the valuation, there are numerous companies with significant debt loads, yet no near-term maturities, that are generating significant and increasing cash flow on a static, or sometimes shrinking, invested capital base.   These companies will be outperformers over time.

Finally, NOLs.  When a company loses money for a long time, they generate a NOL.  This is used to offset future tax payments.  Now, ask yourself this:  What is going to pay for all these bailouts by the government?  Taxes.  What is expected to rise significantly under Obama?  Taxes.  If you can find a company that has significant near-term cash flow, but won’t be paying taxes for a long time due to a large NOL, I believe you can apply a higher multiple on that company’s EBITDA in an improving market, because of higher EBITDA-to-FCF conversion without the tax payment.

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MyCortex is a blog (and hopefully more) that is dedicated to honest, intellectual discourse about anything and everything.