More oil please, says our Cash Magic screen

Like all modern media spectacles, the corporate quarterly earnings report evolved for an American audience.

Note, for example, the emphasis on earnings, rather than assets, cash flows or anything else. In a nation accustomed to ceaseless growth, the bottom line – however massaged, manipulated or adjusted – is the true measure of a company. The only questions are whether The Number beat last quarter or analyst estimates.

In recent years, spectacle has turned into Olympic sport, as the latest god of Silicon Valley descends to smash the latest three-month record. Last week, the earnings of one technology group were billed as a decider for the entire S&P 500, as if the rarefied demand for advanced GPUs were now the defining bellwether for the world’s most important economy.

Fortunately for Nvidia (US:NVDA) and its shareholders, it doesn’t really matter which way you slice it: a combination of sky-high barriers to entry and unprecedented demand for its products mean that for now, the company is currently printing money. Gross profits, operating profits, earnings per share, net income, shareholder equity and free cash flow are all up by a monstrous amount.

Usually, the stars don’t align quite so beautifully. An earnings report may point to progress, or even that much-vaunted new earnings per share (EPS) high, without a parallel rise in cash generation. Frequently, both in the US and increasingly in the UK, returns on capital and per-share metrics are pushed higher by buybacks, rather than new growing sources of profits.

By looking beyond reported or adjusted profits, our Cash Magic screens look for two fundamentals that are often seen as inarguable signs of corporate quality: the ability to generate free cash flow (FCF) and make a decent cash return on capital.  

This isn’t to say that earnings figures don’t matter. Plenty of screens in our stable focus on the income statement, in part because this is what most investors pay attention to. What’s more, cash flows can be comparatively very lumpy. If in its next quarter Nvidia buys Intel (US:INTC), its cash flow statement would take a sharp (though probably quickly digestible) hit, even as its earnings figures (though likely adjusted) marched higher.

Perhaps Nvidia is a bad example to illustrate the difference, given quite how much cash it is making. Which, ultimately, goes a long way towards explaining why it has been such a success. Quite obviously, it has no need to buy Intel. In the three months to 28 April, it generated $14.9bn in free cash flow – that is after accounting for all expenses, taxes, charges and overheads – from a cash-adjusted asset base of $45.6bn, or equity of $49bn. This absurd ratio is only likely to climb.

However, although we do run a (so-far successful, if Nvidia-free) US version of the screen, this week’s focus is on the cash generation chops of UK-listed names. Lately, the original version has been keeping up with a suddenly lively broader market. In the 51 weeks to 22 May 2024, last year’s cohort made a 16.4 per cent total return, compared with 15.4 per cent from the screen’s benchmark, the FTSE All-Share.

Since we started following this screen in 2013, its top 30 stock version has racked up a cumulative total return of 203 per cent, equal to a compound annual growth rate of 11 per cent, while a version that incorporates market momentum (see more below) has returned 136 per cent. Both compare favourably – if less impressively than they once did – to a 111 per cent return from the index. 

While the screens are meant as ideas for further research rather than off-the-shelf portfolios, a hypothetical 1.5 per cent annual charge would reduce the all-time total return for the top 30 screen to 156 per cent and 100 per cent for the momentum version. Their methodologies are as follows:

All FTSE All-Share constituents are ranked by forecast next 12-month FCF yield (FCF per share as a percentage of share price). They are then separately ranked by the cash return on capital invested (CROCI) ratio, which measures how much FCF a company produced for every pound of capital employed over the past year. The two rankings are added together, and a final ranking is created from this.

In its original formulation, the CROCI ratio was calculated by dividing Ebitda by a stock’s total equity value (classed as all forms of shareholder equity plus long-term debt).

Our version of CROCI is taken from the data provider FactSet, which uses a slightly different method it calls cash flow return on invested capital (or CF ROIC). This adds back working capital to the net cash inflow from operating activities in the numerator, while keeping the denominator in line with the original method conceived by analysts at Deutsche Bank.

The idea is to cut out some of the distractions and subjective judgements that find their way into earnings numbers, while distilling a business’s efficiency at converting capital into cash. But it’s not perfect and can provide a flattering picture of capital allocation decisions, depending on when the snapshot is made. Like all ratios, it can be a smart idea to look at CROCI over several periods.

For the ranked version of the screen, the top 30 stocks are selected. For the momentum version of the screen, any stock ranked among the top fifth of those screened is selected if it shows better than average (median average) three-month momentum.

This year, as with 2023, the Cash Magic screen has again shown its preference for oil and gas. Eight of the 30 stocks in the main batch hail from the sector, highlighting the ongoing disconnect between its cash returns and valuations (as marked by the free cash flow yield). Despite beaten-up sentiment and some relatively modest upticks in energy prices, last year’s batch of fossil fuel names performed better than average. For the screen to beat the index this year, they will likely need to repeat the trick.

Both sets of stocks selected by this year’s screen can be found below. Tables with lots more detail on the fundamentals are available to download online.

2024 Cash Magic Top 30

2024 Cash Magic + Momentum