Investing for Cash Flow: A ‘Flow’ Strategy for Market Gains

As gardeners eagerly anticipate spring planting, investors should also have a well-defined plan for navigating the markets. One approach involves identifying stocks with strong free cash flow – companies that generate ample cash after covering operating expenses and capital expenditures. This strategy, often referred to as a ‘flow‘ approach, focuses on finding bargains with robust financial health.

The Free Cash Portfolio: A Track Record of Success

The Free Cash portfolio has demonstrated impressive performance over the long term. From its inception through February 2026, it achieved an average annual gain of 16.9%. This significantly outpaced the Canadian stock market, as represented by the S&P/TSX Composite Index, which averaged 8.1% over the same period. (Note: Returns are based on backtests using Bloomberg monthly data, including dividend reinvestment, but excluding fund fees, taxes, commissions, and other trading costs. Portfolios are equally weighted and rebalanced monthly.)

How the Free Cash Strategy Works

The Free Cash portfolio begins by screening the largest 300 companies on the Toronto Stock Exchange (TSX) by market capitalization. It then focuses on the 10 companies with the lowest positive Enterprise Value to Free Cash Flow (EV/FCF) ratios.

Let’s break down these terms:

• Enterprise Value (EV): A company’s market capitalization plus its net debt.
• Free Cash Flow (FCF): The cash a company generates after accounting for cash outflows to support its operations and maintain its capital assets. It represents the cash available to distribute to shareholders.

A lower EV/FCF ratio generally suggests a company is undervalued relative to its cash-generating ability.

Fixed-Ratio Portfolios: An Alternative Approach

Instead of targeting a fixed number of stocks, investors can employ a fixed-ratio test. This involves investing in all stocks with an EV/FCF ratio below a specific threshold (e.g., 5, 10, 15, or 20). Four such portfolios were tested, and all outperformed the market:

• EV/FCF < 5: 16.9% average annual gain
• EV/FCF < 10: 15.7% average annual gain
• EV/FCF < 15: 17.2% average annual gain
• EV/FCF < 20: 16.6% average annual gain

Over the 26-year period, the number of stocks in these portfolios varied, averaging 6.6 (ratio < 5) to 78.4 (ratio < 20). It’s important to note that in some months, particularly with the stricter ratios, there were very few qualifying stocks.

Navigating Market Risks

While the Free Cash strategy has shown promise, investors should remain aware of external risks. Geopolitical events, such as conflicts, can significantly impact markets and potentially lead to inflation. Staying informed and prepared for such scenarios is crucial.

Looking Ahead

The long-term performance of the Free Cash portfolio remains to be seen. However, with careful planning and a bit of luck, it has the potential to continue delivering strong returns through future market cycles. You can find more details on the Free Cash portfolio and other investment strategies at The Globe and Mail.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.