Friday Morning Coffee Nr. 7: Fishing for the right fishing net

200418 Friday Morning Coffee

Friday Morning Coffee Nr. 7: Fishing for the right fishing net

As an investment manager specialized in European, European Capital Partners’ hunting ground of investment opportunities consists of more than 1 500 listed companies in Europe from which, to build our final portfolio, we need to select between 30 and 40 that fit our investment criteria while trading at a significant discount. In line with our value investment approach, we focus our attention on quality companies exhibiting a strong undervalued earnings capacity, the so-called Earnings Power.  There is no practical way that we can have a qualified opinion on the earnings power of each of one these businesses across such a large universe composed of different sectors and geographies. So, as most stock pickers and value investors, we use screenings to reduce our universe to a more manageable size and focus our attention to more a limited number of promising investment candidates. Over the last 15 years, I have applied our “Entrepreneurial Value” investment philosophy based on earning power, and have consistently fine-tuned these screenings to make sure they yield the best possible ideas for our investment approach.   Amongst our different screenings, the free cash flow yield screen has proven very powerful over time. Free cash flow can be defined in slightly different ways, the most common of which is cash less capital expenditures. Positive free cash flow indicates a company is generating more cash than it needs to run the business, is less reliant on capital markets for financing and can invest in growth opportunities, pay dividends or buy back stock. Furthermore, free cash flow is typically a more robust measure of profitability than earnings, which are subject to manipulation and accounting assumptions.   A simple back-test that excludes transaction costs shows the power of this value metric in Europe over different time periods. Over the last 10 years for example, the top 20% of free cash flow yield stocks less the bottom 20% delivered an annualized spread of 12.3%, as can be seen below. Source: Bloomberg, ECP. Past performance is no guarantee for future results.   Although the free cash flow yield screen appears to be a powerful tool, we do not limit our analysis to it and rely on other proprietary tools to independently generate new investment ideas. These fishing nets are just the first stage of our in-house multi step process. Then, in-depth proprietary fundamental analysis takes over with the objective to identify high quality companies that benefit from a strong competitive advantage to generate high profitability in the future, i.e. a “moat” and avoid the value traps that can hide behind simple metrics. That’s what active stock pickers are being paid a management fee for.