Patience And Free Cash Flow

On a recent trip to visit clients in Denmark, I had some free time and visited the Viking Wooden Ship Museum in Roskilde. The museum houses cargo and military ships made from oak trees, crafted with materials all formed by hand. They took years to build and helped make Denmark one of the world’s most important trading crossroads. Assumedly, the patience required to practice commerce in the 13th century generated massive cash flow for merchants at that time.

We seek companies which generate high and consistent free cash flow. Much like commerce in the 13th century, patience is required to allow free cash flow to grow your capital over the decades. For newbies to us, this is the cash flow of the company minus any and all obligations for the cash which are met during the year. For most companies, the big eater of cash flow is capital spending. Hence, we generally like companies which require less capital spending and have less cyclicality in their business.

Why is free cash flow so important in common stock selection? First, you must think like the owner of an entire business. As a sole owner, the cash flow leftover after all obligations are paid is all yours. The more of it you get, the richer you are! Most investors are too impatient to make wooden ships by hand or wait for this free cash flow to help you get rich slowly in the stock market.

Second, the management of the business can choose to do many things with the leftover cash. They can raise the cash dividend payout or buy back shares in the open market. They could use it to buy other companies and/or expand the business. Or they can let it stack up on their balance sheet as a treasure trove for a rainy day. Regardless of their choice, it is usually causing wealth to build in the company shares.

Two of our other eight criteria speak to the confidence we should have with management’s use of free cash flow. Does the company have a long history of shareholder friendliness the way the Danish people had a long history of building superior wooden boats? Does the company have strong insider ownership, preferably with recent insider or smart money purchases? If the answer is yes, we usually will be comfortable with the management’s choice of what to do with the wonderful cash hoard leftover each year.

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Disclosure: This article contains information and opinions based on data obtained from reliable sources, which is current as of the publication date, and does not constitute a recommendation ...

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