Blue Tower Asset Management annual letter for 2014 discussing free cash flow and an active management philosophy.
See Part I here.
Blue Tower Asset Management – A Note on Free Cash Flow
Many people focus on a company’s ability to generate earnings as a measure of value.
Earnings in of themselves are not the best metric as they can be manipulated through the use of accounting techniques. A better measure of a company’s financial performance which has become the most important metric for many value investors is their ability to generate free cash flows. The common definition of free cash flow is:
However, this may not always be a fair evaluation of a company’s “true” free cash flow as even free cash flow can be manipulated.
It is possible for a company to be making acquisitions that are necessary to maintain the company’s competitive advantage. In this manner, these acquisitions become maintenance capital expenditure in disguise. This is particularly common for technology and pharmaceutical companies. If it appears that many of a company’s acquisitions are of this nature, then a wise investor should subtract net acquisition costs from the free cash flow calculated above. Additionally, it’s important to think of the fact that acquisitions are in many ways a capital expenditure and can be replacement for traditional acts of capital expenditure such as equipment purchases and R&D. This may seem like an unusual and unlikely transaction to occur in real business practices, but a very similar thing is currently happening in the technology industry. Purchases of companies such as the $3.2 billion purchase of Nest Labs by Google or the $5 billion purchase of NDS by Cisco are both examples of this. If these companies had invested their own cash into developing the intellectual property and tangible assets of these companies, they would have had to record it as an expense which would be reflected in their FCF.
An additional issue with a focus on free cash flow is off-balance sheet obligations in the form of operating leases. Companies may have an incentive to structure their purchases as operating leases rather than financial leases since operating leases are not recorded on the balance sheet and do not affect free cash flow in the initial year of the equipment acquisition. In subsequent years the company will have to recognize the lease payments on their income statement, but the accounting of these types of transactions does not adequately reflect the underlying economic realities. The Financial Accounting Standards Board is aware of this loophole and is currently discussing making changes in FASB Topic 840 to force the capitalizing of operating leases on the balance sheet of companies. The SEC estimated in a 2005 report that the total value of the off balance sheet lease obligations to publically traded US companies was approximately $1.25 trillion showing that this issue has become a serious distortion to reported financials in the United States.1
Despite these issues, I still believe that normalized free cash flow yield is a great metric to use in the analysis of companies for investment. During analysis of securities, I keep these issues in mind and make the appropriate adjustments to projections of free cash flow yield in order to get a better picture of the opportunities for client’s capital.
Blue Tower Asset Management – An Active Philosophy
I believe human understanding and machine intelligence are complementary with the sum of their combination greater than its individual parts. Blue Tower is intended to be an expression of this complementary approach.
2014 was a year that saw continued flows to passive strategies from active management. Collectively, investors pulled $12.7B from active funds, while passive strategies gained $244B! A major factor fueling this is the underperformance that active managers have had this year. As more money flows to passive management, I expect the inefficiency of financial markets will increase with correspondingly more mispriced securities. Additionally, flows to index funds will inflate asset price bubbles as overpriced securities will attract funds equal to their portion of the float-weighted benchmark. These mispricings create opportunities for truly active managers.
A significant issue with comparing performance between active and passive management is that many managers who claim to be active are really just “closet indexers.” When a mutual fund owns hundreds of different positions, it is difficult to believe that the managers are closely following developments in all of the fund’s holdings and not just replicating their benchmark. A paper from Martijn Cremers and Antti Petajisto of the Yale School of Management investigating the active share (measure of the degree to which holdings in a portfolio differ from the benchmark index) of actively-managed strategies has found that the amount of focus a manager places in his strategy is significant2. They found that the strategies with the highest active share significantly outperformed their benchmarks, even net of fees. Meanwhile, closet indexing funds (low active share) tended to underperform. They also found that strategies with a small capital base were more likely to have high active share which is to be expected considering the difficulty for a huge fund to effectively deploy capital to niche opportunities.