SmicroCaps

 

               Last week, I attended an event hosted by the New York Society of Security Analysts in midtown Manhattan. The evening centered on George C. Christy and his book Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks. Along with degrees from Princeton University and the University of Chicago Booth School of Business, Mr. Christy has over thirty years of professional financial experience including time at GE Capital.  He now focuses on financial writing, including free cash flow analysis and methodologies, through his company Oakdale Advisors. Despite his impressive background which also includes many years in corporate banking, he remains quite humble. “Anyone in this room could have written this book,” he said. He was, after all, in a room with many Wall Street professionals, some of which have decades of their own experience in the credit and equity markets. Like many of the attendees, I had a chance to speak directly with Mr. Christy before his presentation.   He mentioned that Seeking Alpha is a great resource for reviewing conference call transcripts but would like to see more international corporate transcripts. I’m not sure how useful that would be for foreign language conferences, particularly due to custom differences that a literal translator like Google Translate would fail to capture. Regardless, it shows how investors of all backgrounds find resources at Seeking Alpha.

 

After the networking session, Mr. Christy began by stating the well known belief that most of the “accounting fog” in modern financial statements comes from accrual accounting. He referenced Georgia Tech accounting professor Charles Mulford’s book Creative Cash Flow Reporting for further demonstration (note that Mulford also endorsed Christy’s book, so there’s a bit of cross-promotional bias there). Public companies are managed for earnings per share rather than cash generated for shareholders. While these are solid points, he made a very bold claim by stating that “only 10-20% of CEOs can define free cash flow.” Considering that 39% of S&P 500 CEOs have MBAs (and, according to Spencer Stuart, 22% of the S&P 500 CEOs have MBAs from Harvard), that claim may be a bit exaggerated unless introductory accounting and finance classes are not taught anywhere else but Cambridge. It was much easier to believe his statement that, without the help of their auditors, “before (Sarbanes-Oxley), many small microcap companies could not generate a cash flow statement.”  Much earlier in his career, Mr. Christy worked at a microcap investor relations firm and has particular expertise on that subject.

 

Today, his efforts focus on writing and the free cash flow/investor return methodology that is detailed in his book. While I have not read Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks, the presentation included a brief summary of its nine chapters, beginning with “Investing 101” and finishing up with “Finding Great Stocks” after his approach has been fully explained. My main take away from the evening is the emphasis on free cash flow deployment and its ability to add to (or subtract from) shareholder value. “Companies will be able to differentiate themselves through efficient use of capital,” Mr. Christy noted. This is accomplished by using capital either for acquisitions, dividends, as well as debt and share repurchases. Along with calculating incremental cash flow improvements due to operations, all of the components are in place to estimate a stock’s target price.  A Free Cash Flow Worksheet and a detailed example on Six Restaurants, both in Microsoft Excel format, are available at publisher Wiley’s website. The worksheet is easily adaptable to any public company’s financial data and is intended to complement the book. His example, which is roughly two years old, examines McDonald’s (MCD) in contrast to Panera Bread (PNRA), The Cheesecake Factory (CAKE), PF Chang’s China Bistro (PCFB) and the two companies (Applebee’s and IHOP) that merged to form DineEquity (DIN). MCD’s performance over that time frame has been relatively close to these estimates.

 

              

Mr. Christy’s approach is novel and quite elegant, but, like all valuation methodologies, is not without criticism. Most notably is the use of current stock price as a starting point rather than a pure bottom up approach of determining equity value such as a discounted cash flow model. Plain use of dividend yield, which one of the attendees brought up in the Q&A session, is also dependent on taxation policies, payout ratio and shareholder preference for dividends. For example, if an investor buys a company for a great management team who makes excellent use of capital, retentions or buybacks are preferred. Though this is easily solved with a dividend reinvestment plan (DRIP), the argument makes adding the dividend yield here redundant and overestimates expected return. Finally, there was very little specific mention of how to estimate value added due to acquisitions. This, however, can be a highly strategic and qualitative subject that is difficult to quantify even for the most sophisticated industry analysts.

 

In summary, Mr. Christy’s presentation was extremely insightful and left many attendees eager to pick up Free Cash Flow: Seeing Through the Accounting Fog Machine to Find Great Stocks. If you are an investor who is looking to discover a new valuation methodology, scrutinize free cash flow generation/deployment and identify companies with above average capital management capabilities, then keep his book in mind. However, as Mr. Christy reminded us all, there is no single appropriate valuation technique for every stock.