Pushing The Powder Keg Up The Hill

Golden Cash Flow Kings

To say that momentum & growth stocks have had an amazing run for the past year is a gross understatement. The returns have been fabulous and fortunes have been made. But with the market at 190% of GDP and the poster boy Tesla trading at 30 times sales where the S&P500 long term average is closer to 2 times, is it really time to back up the truck?

 

But where does one find value? Sure the argument of the various tech companies growing into their respective extended valuation metrics certainly looks appealing with the monetary froth in the markets these days. But as a responsible investor wanting some semblance of fundamentals, where can one look and what should you look for?

Two fantastic measures of a healthy company are Return on Equity (ROE) and Free Cash Flow.

ROE is really a measure of management effectiveness of the resources available to them. It is the amount of net profit divided by the shareholder equity (total assets less total liabilities). A company that has a high ROE is more likely able to generate high amounts of cash internally. More cash means more opportunities and less reliance on the capital markets for growth and shareholder enhancement. So generally, the higher ROE the better especially if compared to its peers.

Free Cash Flow (FCF) is very important measure because, quite frankly, very few companies have it. The very premise that a company has free cash flow is either an indicator that a company is very well run or is in a sector that is spinning off good profit. Either way, this is a good thing for shareholders. In its simplest definition free cash flow can be defined as Operating Cash less Capital Expenditures. The result of Free Cash Flow is unencumbered cash that a company can use to pursue opportunities to enhance shareholder value. A company can use it to pay down debt, buy competitors, or pay a dividend. When a company pays their dividend with FCF, there is no dilution, no interest charges or financing fees to pay – just pure cash paid to shareholders.

When there is a combo of strong ROE and lots of FCF – you can attract the attention of serious value investors.

With the market absolutely picked over in the traditional more well-known sectors – where can an investor find this golden combo? We have identified four potential rock stars that are worthy of merit. And if we need someone to ring the bell – look no further than the king of value investors – Warren Buffet. Last year, second quarter, he sold the airlines and his favorite bank and for the first time in decades, bought a gold mining company! Now why would he do that – outside of the obvious that gold is a great hedge against the coming monetary inflation and already had an impressive year. A gold mining stock is not physical gold but it offers some operational leverage and compelling metrics.

Legendary investor Buffet invested in Barrick Gold (ABX, GOLD). As one of the world’s largest physical gold producers, Barrick Gold has an ROE of 14% and an impressive 151% growth in Free Cash Flow in Q3 2020. No surprise, management approved a 12.5% increase in the dividend. In a sector known for destroying capital, Barrick Gold now boasts a war chest of $4.74B in cash. Yet the market has not given this company the valuation it could deserve – a paltry 9x enterprise value/ EBITDA where we believe 15x would be reasonable given the growth and profitability prospects

AngloGold Ashanti (AU) is another very interesting value play. Based out of South Africa but listed on the NYSE, it primarily mines gold but as well as silver and uranium. They operate 14 mines and three projects in nine countries in South Africa, Africa, the Americas and Australia. Sales last quarter were over $1B and profit over $250M. With an impressive 21.5% ROE and 290% growth in Free Cash Flow totaling $339M for Q3 2020, this is another FCF rock star. They currently have banked $1.3B in cash ready for shareholders. Management has indicated they will boost the dividend in the coming quarters. Yet the stock trades at an anemic 7x Enterprise Value/EBITDA. We would not be surprised to see a repricing to 12x EV/EBITDA.

 

Our third selection, although in no particular order, has the biggest cash balance of them all at $5.14B. Newmont Corporation (NEM) is both a producer and explorer of gold, silver, zinc and lead and operates in the USA, Canada, Dominican Republic, the Americas and Australia. ROE of 10.5% is not as impressive as their sector competitors but had a mammoth year of $11B in sales. Free Cash Flow for last reported quarter 2020 came in at a record $1.3B and again management intends to increase dividends and buyback stock for shareholders. Clearly management is doing things right and on task. The market quite likes this performance and is paying up with an 10x Enterprise Value/EBITDA however we believe we could very well see an improvement to 14x.

 

Lastly, we have our Canadian darling gold mining stock of Kinross (K, KGC). With proven and probable reserves of gold 24.3M oz and silver 55.7M oz, it is definitely a world class precious metal mining company. The company yearly sales were an impressive $4B and a cash balance of $1B. Management has delivered an impressive 20.3% ROE and is recording Free Cash Flow at a blistering pace. A leading brokerage house expects Kinross to deliver over $800M in record Free Cash Flow for 4Q 2020 as production is up and cost are coming down. The company trades at the lowest EV/EBITDA of 6.4x. We feel comfortable in suggesting that a double from here 13x EV/EBITDA would not be unreasonable.

 

These are our Free Cash Flow Kings.

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