Cash flow management a key investment criterion

DeMore said she and her team work hard to understand the trajectory of earnings and cash flow a company commands. More importantly, they also look at whether management is willing to reinvest in the business to drive future earnings or greater cash flows.

“We don’t always want management teams to return the most cash to us as they possibly can,” she said. “Nothing makes the stock work so well as when you have a differentiated view on earnings and cash flow. And when that generates cash that can be deployed into growing the business or buying back shares, that’s another way to juice up earnings or cash flow per share.”

She said her buy decisions are fuelled by quantitative analysis that scores stocks within a sector according to cash flow, earnings revisions and shareholder returns. She particularly likes companies that compare favourably to similar businesses in the same industry.

“We’re looking for companies that are trading cheap relative to peers despite having similar prospects, or that are trading in line with peers but have much better prospects, or that are cheap relative to their history despite having faster earnings growth and lower leverage,” she said. “We’re always looking to harness our valuation relative to something.”

DeMore said she holds stocks for an average of five years to allow valuation to matriculate.

“We own names where there are multiple ways to win, where different parts of the thesis are firing at different times,” she said. “So, when we buy a name, we really intend to own it for a long time.”

For example, DeMore and her team purchased shares of Connecticut-based Charter Communications Inc. after a weak quarter for the internet provider. The company was trying to integrate an acquisition, and the prevailing wisdom was that broadband subscriber growth was about to decelerate.

As the team suspected, broadband subscriber growth did not decelerate, and over the course of four years the company squeezed new synergies out of its acquisition. Charter reduced its capital expenditures, cash freed up, and the company ended up buying back a quarter of its outstanding shares.

Another example is Texas-based Southwest Airlines Co., which boasted low leverage relative to peers. DeMore’s team felt the company would come out of Covid in a much better competitive position, picking up routes that other carriers had to give up due to the pandemic, and offering low-cost tickets enabled by an extremely efficient cost base.

Holding on despite Covid fears has proved rewarding.

“Southwest Airlines is focused on domestic leisure travel. Where business travel is probably going to come back slowly and maybe not even to prior levels, Southwest is primed to benefit from the return to normal at least for consumers,” she said. “Their shares have about recovered to where they were pre-Covid, but we don’t think that that truly values the opportunities that they have ahead of them.”

DeMore said while buying is about thoughtful analysis, knowing when to sell is about intellectual honesty.

For example, despite the amazing run Apple Inc. has had over the past 15 years, its shares were trading at 30 times earnings by the mid-point of 2020, double its historic average.

“Apple was actually barely growing earnings in the last several years. Its five-years earnings CAGR [compound annual growth rate] is about 2%,” she said. “For us, we just felt like that was too rich. We had trimmed it earlier [in 2020], and we liquidated it in July.”

DeMore’s disciplined approach informs her portfolio construction too.

“We run stress tests to see how the portfolio would have done in periods where, say, the oil price fell 30%, or where growth outperformed value by 12%,” she said. “What we’re doing in these stress tests is making sure that our portfolio is not positioned to either outperform or underperform, based on any external shocks.”

That approach paid off meaningfully during the downturn in Q1 2020, and the rebound in the second quarter of 2020.

“We spend a lot of time making sure that we size positions and sector exposures in a way that the portfolio’s performance is not going to be at the whim of an external shock, whether that be Covid, [a] big move in interest rate expectations, or a big-moving currency,” she said. “That’s how we make sure that all the work we do on the stocks drives the portfolio.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.