Liontrust Responsible Capitalism Report 2024 - Flipbook - Page 100
Cashflow Solution team’s investment process
The Cashflow Solution process can be best described as focused
on the forensic analysis of historic cash flows and balance sheet
development as presented by companies in their annual report
and accounts.
The team focuses on the historic cash flows generated and
invested by companies to support their forecast profits growth.
As forecasts are often unreliable, the scale of cash invested to
support forecasts is key.
In the team’s experience, companies that generate significant free
cash flow after investments prove to be rewarding stock market
purchases.
Companies that invest significantly more cash than they can produce
to back bold forecasts of future growth often disappoint. Therefore the
STAGE
1
STAGE
2
team pays particular attention to both the quality and sustainability of
company cash flow and the valuation investors attach to it.
For long/short portfolios the aim of the investment process is
to complement the team’s long investments with short sales of
expensive companies run by company managers who combine
over-confidence in their forecasting ability with a willingness to
back their forecasts with substantial growth in operating assets
such as property, equipment and stock.
They tend to generate very significant cash outflows after
investments and carry significant forecast risk. If their profit
forecasts prove too optimistic, the toxic blend of high financial
leverage as a result of significant cumulative cash outflows,
falling profitability and an expensive valuation often leads to a
devastating impact on share price performance.
DEFINING INVESTABLE UNIVERSE
The first stage is to define the investable universe of
companies with sufficient liquidity within the target
geographic region.
CREATING THE CASHFLOW CHAMPIONS WATCHLIST
In order to identify companies’ annual cash flow, balance
sheet development and valuation efficiently across all
equity markets, the team uses a simple screen as a starting
point for further qualitative analysis. The investment screen
consists of two cash flow ratios that are combined equally
to highlight the characteristics that the team seeks.
The first is a quality screen (cash flow relative to operating
assets) and the second is a value screen (cash flow relative
to market value).
• Cash flow relative to operating assets: This ratio gives
the managers a good idea of cash flow profitability and
the scale of asset investment that has been undertaken. It
provides them with a good sense of management prudence,
financial leverage and sustainable growth potential.
100 - Responsible Capitalism Report 2023
• Cash flow relative to market value: The second ratio
ranks companies according to how investors value a
company’s cash flow. It provides the managers with a
good indication of investors’ expectations regarding
forecast growth and the potential stock return if those
forecasts are wrong.
The ratios have been developed over a number of years and
contain the managers’ own proprietary definition of operating
assets and cyclically adjusted, normalised cash flow (in a
normal year excluding temporary or exceptional items).
Stocks are ranked in order of attractiveness across the two
screens. The top 20%, or quintile, comprises the Cashflow
Champions from which stock selections will be made
for long-only portfolios. The top 20% of the list contains
companies that are cheaper than the market (as measured
by cash flow yield) with cash returns on operating assets
that are better than the market.