For many investors, the first thing they look for in a company’s financial statements is profits. If earnings are going up, they believe that the company is doing well.
Generally this may be true, but with accrual accounting, revenues and expenses are recorded when they occur, not when cash actually changes hands. One might ask what the difference is, but any business relies on generating cash. The income statement, however, records non-cash revenue and expenses as well, which can distort the health of the company.
A company must have cash to pay taxes, buy more inventory, pay its employees and distribute dividends. Having cash on hand also provides a buffer against future financial problems. If cash is not flowing into the business, it could therefore be a sign of underlying challenges.
“Historically, investors have generally focused more on accounting earnings,” says Mark Dunley-Owen, manager of the Allan Gray Stable Fund. “That may be changing because companies are customising accounting earnings more so than they did in the past, so investors are moving towards using cash flows.”
The most obvious example where weak cash flow was a sign of trouble was Steinhoff. The company was reporting attractive earnings, but as Adrian Saville, CEO of Cannon Asset Managers, noted shortly after the company’s share price collapsed:
“If you can get past the fairly anaemic return on invested capital and satisfy yourself that the accounting number is what it is, it really becomes a glaring anomaly when you go look for the cash flow. The cash just isn’t there.”
Dunley-Owen says that while Steinhoff’s business model was flawed and one mustn’t assume that every company with cash flow problems is going to run into a similar situation, there are two other prominent local examples where cash flows have recently raised red flags.
“MTN and Aspen are companies that we historically believed were expensive because their cash flows weren’t being valued correctly,” he says. “We were cautious on their cash flows two to three years ago – not because their business models were flawed, but because we thought they didn’t make as much cash as the price suggested.”
In MTN’s case, the majority of cash was being generated in the Nigerian business, and the sustainability of that was questionable due to a number of factors. With Aspen, earnings were showing healthy growth, but cumulative cash flows hadn’t gone up in more than a decade.
Another broad example is the local listed property sector, which showed outstanding performance for a long time, but has run into a number of problems over the last few years.
“No one looks at cash flows in the property sector,” says Dunley-Owen. “We think you should.”
It can be very difficult to analyse the cash flows of real estate investment trusts (Reits) because there tends to be a lot of inorganic activity – in other words, buying and selling of assets, as opposed to growth from the existing business.
“Any company that is acquisitive has a similar problem,” says Dunley-Owen. “Steinhoff was a classic example of a company that bought and sold a lot, which made it hard to see what was going on with its organic cash flows.”
In the property sector specifically, Allan Gray is cautious on the assertion by property companies that capital expenditure should only be seen as an investment and not a cost.
“Our view is that at least some portion of any capital expenditure is maintenance, so it is a cost,” Dunley-Owen argues. “Reits have to pay out their full earnings as dividends, but they don’t take capital expenditure off that. Our view is that most Reits distribute more cash than they earn, and that can’t go on indefinitely.”
Conversely, cash flow can also indicate when a company may be undervalued. Given that it is an excellent indicator of the health of a business, if cash flows are strong even when earnings are depressed, there is a likelihood that future returns will be good.
“Where we find undervalued cash flow today is with some of the miners,” says Dunley-Owen. “Interestingly, if you look back to 10 years ago, miners weren’t making much cash but they were highly priced because investors weren’t accounting for capital expenditure. Today they are making a lot of cash yet many investors don’t like them. We believe there are opportunities.”
Another area where cash flows are potentially being undervalued is in the mid-cap industrial space. These are predominantly ‘SA Inc’ companies exposed to the South African economy, and they have fallen heavily out of favour due to the current local weakness.
However, as PSG Asset Management equity analyst Mikhail Motala points out, the free cash flows being generated by companies like Hudaco and AECI make them look attractive, regardless of how the economy performs.
“Most of our ‘SA Inc’ holdings trade at free cash flow yields of 10% or above – very attractive entry points relative to both history and other opportunities globally,” Motala notes. “As free cash flow is a measure of the cash available to distribute to shareholders or expand the business, these companies could effectively return well over 15% a year, even if we assume that they only grow by inflation in the absence of any GDP growth.”