Cash Flows Point The Way

For a company that is the global leader in cosmetics, L'Oreal had no way of putting any gloss on its outlook in late 2014. CEO Jean-Paul Agon announced in November that third-quarter sales would advance by only 2.3% on a like-for-like basis, far below analyst estimates. It was turning out to be the company’s worst year since 2009.

But viewed through another lens, investors could see a very different story. L’Oréal’s cash flows have remained high and stable for more than a decade— even through challenging periods after the global financial crisis. Resilient cash flows, along with a broader fundamental analysis, indicated that L’Oréal’s underlying business remained intact and was likely to deliver solid growth and investment returns over the long term.

L’Oréal is a good example of how to select stocks using a cash-flow approach. We measure a company’s cash-generating track record by looking at its cash-flow return on investment (CFROI): essentially the annual percentage rate of return produced by a company’s net cash flows over time. Over the past decade, L’Oréal’s CFROI has remained at or above 20% (Display), compared with an average of about 12% for global equities. About 40% of its business is in emerging markets, which is likely to drive future growth. And the company benefits from global brand recognition and a perception of quality that supports high pricing for its products and fuels profitability. In our view, all of these traits—which underpin dependable high cash flows—suggest that L’Oréal should be able to withstand a bout of market turbulence and return to its path of long-term growth.

There are several key benefits to putting CFROI at the heart of an investment process.

 

We believe that using cash metrics rather than accounting earnings helps identify companies generating strong and sustainable returns. When combined with detailed research on industry and company fundamentals like revenue trends, margins, competitive positioning and balance sheet health, it helps investors obtain effective intelligence on a company’s future growth and stock price appreciation potential.

Why Is CFROI Important?

CFROI might not be a standard component in an equity investor’s tool kit. Yet our research shows that global stocks with high and stable CFROI have outperformed the MSCI All Country World Index and delivered stronger risk-adjusted returns over time (Display). We believe there are several clear benefits to putting CFROI at the heart of an investment process.

• Cash is transparent
• Noise is reduced
• Returns are more likely to be sustainable