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Want lower returns? Ignore these red flag ratios

To become a better investor you have improve your knowledge all the time through reading good research and studying other great investors.

This is something we do all the time to help you improve the returns you can earn using the Quant Investing stock screener as well as in the Quant Value newsletter.

Red flags added to the stock screener

Our continuing research has led to the addition of three red flag indicators to the screener.

A red flag indicator is a ratio that tells you if there is something in a company's financial results that you need to be careful of or that you must investigate further.

Here are the three red flag indicators added:

 

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.

 

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