Cash flow portfolio
(update June 2016)

Last week I provided an update on the Magic Formula portfolios that I set up in January (click here to read more on this). It's part of my experiment on whether rules-based investing which involves choosing shares just on numbers alone can deliver good results for investors. I want to know if they can make money and beat the performance of the stock market as a whole.

It's unfair to judge a strategy on a few months performance. I think you need to look at periods of at least three years and preferably five years before you can come to any reasonable conclusions about how good or bad it might be. So far my Magic Formula portfolios are underperforming the market.

After the falls in the stock market during the last week (mid June 2016), a simple Magic Formula portfolio is now losing money for the year as a whole. A lease-adjusted Magic Formula and EBIT yield portfolios are making money but are seriously underperforming the market.

In January I also set up a test portfolio based on cash flow metrics (see Cash flow portfolios for more on this). Regular readers of my articles will know that I am a big fan of using free cash flow returns on capital (CROCI) as a way of identifying high quality companies. So I set up a portfolio with the following characteristics:

  1. 20 shares from different sectors of the stock market equally weighted within a fictional £100,000 portfolio.
  2. Financial shares were excluded.
  3. Dealing costs, stamp duty and bid-offer spreads taken into account.
  4. Minimum trailing CROCI of at least 10%.
  5. Minimum free cash flow yield of at least 5%.
  6. Minimum market capitalisation of £100m.
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How has it performed?

Not well is the short answer.

Cash flow portfolio
Starting Cash£100,000
Cash Invested£99,248.52
Portfolio Value£101,276.75
Total Return1.28%
Total Return on cash invested2.04%
FTSE All Share5.80%

No of winning shares

10
No of losing shares10

Performance measured from 22/1/2016 to 14.45 on 15/6/2016.

Excluding the impact of dealing costs, the portfolio has made money by posting a total return of 2.04%. When costs are taken into account the total return falls to a measly 1.28%. This compares with the FTSE-All Share index which has delivered a total return of 5.8%.

2016 has been a difficult year for stock market investors so far with investors constantly fretting about issues such as when interest rates will go up, the effect of the UK leaving the EU and the outlook for company profits. Picking winners in this kind of market has not been easy.

The cash flow portfolio has had an equal amount of winning and losing shares so far.

Biggest winnersTotal ReturnFCF yield Jan (%)FCF yield now (%)
Polymetal63.10%25.320.4
Indivior45.50%23.812.5
Gem Diamonds31.00%13.26.6
GVC Holdings24.50%8.85.3

There have been some big winners such as Polymetal and Indivior which were offering big trailing free cash flow yields back in January and still do now. Gem Diamonds and GVC Holdings don't look as cheaply valued on the same basis now.

There have been some howlers as well.

Biggest losersTotal ReturnFCF yield Jan(%)FCF yield now(%)
Lakehouse-65.30%10.935.7
Alternative Networks-36.50%6.39.7
Matchtech-17.90%7.710.5
Go-Ahead-15.40%31.338.5

Lakehouse shares have been hammered following a massive profits warning in February and the management turmoil that followed. Alternative Networks also warned on its profits in February and has seen its shares fall significantly as a result.

Remember this portfolio has been put together without any further research on the companies and shares involved. The only selection criteria are two numbers - the last reported CROCI and trailing free cash flow yields. With this kind of approach you are pretty much flying blind. You have no idea whether the current free cash flow performance of the company is a good indication of its long-term prospects.

The hope is that by owning 20 shares you will bag a decent number of winners to offset the losers. So far, this approach is what has happened with the gains from the 10 winning shares almost completely offsetting the losses from the other 10.

As I said back in January, I would not invest my own money this way but I want to keep an open mind and see how this unemotional approach to investing pans out. That said, I can't help thinking that even a small bit of digging and a more disciplined approach might have kept me away from some of the losing shares. For example, was Go-Ahead's free cash flow really sustainable? A high free cash flow yield of over 30% is usually a sign that the stock market doesn't believe that free cash will grow. There are few free lunches like this in the stock market although sometimes you can find them.

A quick glance a Go-Ahead's cash flow statement would have quickly told you that its free cash flow was boosted by a significant one off working capital inflow that won't be repeated going forward. Simple formula-based investing ignores important things like this.

To sum up

  1. The cash flow portfolio is not doing well but has made a small amount of money so far.
  2. The gains from winning shares have largely been wiped out by the losses from the losing shares.
  3. Some cheap shares identified in January have done well.
  4. Other cheap shares appear to have been value traps - maybe they were cheap for a reason.
  5. Simple rules-based investing ignores important facts about a company's performance.
  6. A large diversified portfolio is a hedge against what you ignore. It doesn't work out all the time.

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.