Ignore these red flag ratios if you want lower returns
You know in order to become a better investor you have expand your knowledge all the time through reading good research studies and studying other great investors.
Improve all the time
This is something I do all the time to improve the returns of the companies I recommend to you in the screener
as well as in the Quant Value newsletter
Red flags added to the model
This has led to the addition of three red flag indicators to the screener.
A red flag indicator is a ratio you can calculate, using information from a company’s financial statements, that tells you if there is something that you need to be careful of or that you must investigate further.
Here are the three red flag indicators added recently:
Red flag 1 – Free cash flow to debt ratio
The free cash flow (FCF) to long-term debt ratio indicates how long it may take a company to pay back its outstanding debt, given its current level of FCF.
The ratio thus gives you an indication of the financial health of the company.
Good ratio to generate out-performance
A research study in the book Quantitative Strategies for Achieving Alpha showed that the 20% of companies with a high value of FCF to debt (companies that could easily pay back their debt) would have given you substantially better returns than the market and, as you can imagine, substantially better returns than companies with a low FCF to debt ratio.
Red flag 2 – Capital expenditure to property, plant and equipment
The ratio Capital expenditure (Capex) to property, plant and equipment (PP&E) tells you what the capital intensity of a company is or the investment in capital assets, such as machinery, office equipment, and buildings, necessary to manufacture products or provide services.
Capital intensive industries
Examples of capital-intensive industries are automobile manufacturing, airlines, steel production, oil production and refining, and chemicals production.
In each of these industries, large capital investments are required to manufacture products or to provide services.
Low capital intensity – better returns
The book Quantitative Strategies for Achieving Alpha also tested the impact of capital intensity on stock market returns and found that companies whose capital spending is low relative to existing PP&E generates higher returns compared to the market and capital intensive companies.
Red flag 3 – Operating cash flow to capital expenditure
The ratio operating cash flow to capital expenditures (Capex) tells you how much cash a company has available to fund Capex, a necessary outflow of cash to repair and replace PP&E.
High ratio is a healthy company
As you can imagine, companies that generate a lot of operating cash flow relative to their capital spending needs, have excess cash that can be used to expand the business, pay dividends, repurchase shares, reduce debt and make acquisitions.
These companies are also less likely to have problems servicing their debts.
High ratio equals higher returns
Back tested studies have also confirmed that companies that have a high operating cash flow to Capex ratio generate higher stock market returns, out-performing not only companies that don’t generate as much operating cash flow compared to Capex but also the market overall.
Your continuous improvement analyst
Tim du Toit
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