Podcast 14th August 2015
Free cash flow generating companies are seen as solid, fundamentally strong and usually good long term investment bets. Companies that generate free cash work their assets well, use internal resources for growth and have strong margins and return on capital.
The question is what do companies do with the free cash they generate? Accumulation of cash can become a burden if the cash is not invested properly. Accumulation of cash is also seen as a company being slow to reinvest for the future. Microsoft is one good example of a high free cash generating company that did not invest for the future resulting in long term undperformance of the stock as compared to other tech giants like Apple and Google.
High dividend payouts and share buybacks are ways to reduce cash levels in a company. However this really does not generate shareholder value as seen by the example of Microsoft. There are many companies like Microsoft throwing up high free cash flows but not delivering shareholder value.
Now coming back to the question of whether to invest in free cash flow generating companies. Such companies will give dividends and the share price may stay stable for long periods of time. Great, but you require growth in capital and dividend yields are too low to make any meaningful addition to your savings.
Companies that can show high growth even as they generate free cash are good investments as you get a fundamentally strong company with strong growth. Apple and Google are two companies that have show high growth even as they generated high free cash flows. But the market will always worry about whether these companies can keep growing at a hectic pace. At some point of time, Apple and Google can also become a Microsoft unless they are able to innovate and grow. At present both the companies have shown that they can grow despite their size and cash loads.
The concept of free cash does not exist in the private space. Money is pouring into companies such as Uber as they grow at a hectic pace burning cash in the process. In a short period of time, such companies have grown to multi billion dollar valuations purely on the growth they are able to generate.
Is Free Cash as a concept dying out? The answer is yes and no. Companies that can grow at a hectic pace should at some point of time stop and earn the rewards for growth, which is free cash. So markets are giving high valuations for growth in expectation of future free cash flows.
Companies that have already grown and are generating free cash may not be able to grow at a sustained high pace, due to various reasons. Such companies are in danger of being left behind or in danger of losing out on high growth opportunities.
You are better off investing in companies that are growing fast with expectations of generating free cash in the future.
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