Comments on: Consistent Cash Creators, Part 2: Linear vs. Exponential Growth

By: Alan

Alan — Sun, 13 Jun 2010 04:07:32 +0000

Hi George,

Happened to stumble on your website from a friend’s recommendation. I must say that your method is a nice and elegant tool to analyze companies.

From what I understand, am I right to say that your method suggests that if I identify a company’s FCF growth to have strong linearity (i.e. r2>.95) then there is a very high possibility that the next few years of FCF should follow that trend?

Secondly, u mentioned this model uses regression. From what I understand, isn’t this finding the linearity of FCF? Whereas regression is the concept of finding a relationship between two variable data sets? For example, beta is a regression of the benchmark index against the stock price.

By: Consistent Cash Creators Value Stock Screen | Fat Pitch Financials

Consistent Cash Creators Value Stock Screen | Fat Pitch Financials — Wed, 21 Apr 2010 22:38:19 +0000

[...] of free cash flows over the past seven year and determine how close free cash flows followed a linear trend using the r-squared statistic. I then only keep companies that have r-square values greater than 0.90. This reduced the remaining [...]

By: John

John — Wed, 26 Mar 2008 15:57:05 +0000

I agree that there are substantial problems with the CAPM approach, but you wouldn’t be testing for CAPM if you did a Fama-MacBeth regression here. You would essentially be testing if there is a growth stability effect (like value or size effect). In others words, you would test the portfolios created by sorting based on R^2 to see if there is a risk premium associated with the stability of cash generation. This is similar to the work of Fama and French in 92 and 93 testing for the value and size effects. The only reason I mentioned other factors is because current work running Fama-MacBeth regressions control using multi-factor models (at least) instead of just CAPM.

Fama and French ran their regressions with portfolios formed once a year. I imagine you could probably get enough power if you had 20 years of data if yours is yearly. Without a long enough, or fine enough (yours couldn’t be more than quarterly) data, it wouldn’t be worth it. However, it would still be interesting.

By: George

George — Tue, 25 Mar 2008 20:47:27 +0000

Hi John,
Thank you for the suggestion. I’m not familiar with Fama-MacBeth regression (due to my lack of training in finance) but from a quick Google search it appears that this would require more historical market data than my database currently contains. Plus, I’m not really a fan of the CAPM and the Fama-MacBeth appears to be used to estimate CAPM parameters.

By: John

John — Tue, 25 Mar 2008 19:37:22 +0000

George,
May I suggest running a Fama-MacBeth regression on these companies: you could sort them into groups/portfolios based on R^2 and then regress the portfolios against the market and other factors?

By: George

George — Tue, 25 Mar 2008 11:59:40 +0000

It all depends on your goal, Vivek. The goal of Consistent Cash Creators is to find the easiest companies to predict their future owner earnings. For the most part, I predicted that the resulting companies would be simple businesses with low capital requirements, just the kind of businesses Buffett loves. I use free cash flows as a proxy for owner’s earnings. While using cash flows from operations might be a “smoother” and more predictive variable, it would fail to let us know about businesses that require irregular infusions of cash. These types of businesses can drain free cash flows quickly, even though cash flow from operations is consistently positive and growing.

By: Vivek

Vivek — Tue, 25 Mar 2008 05:40:25 +0000

George,

Correct me if I am wrong here, but shouldn’t you be using an independent variable that has a greater predictive power for explaining the changes in FCF? Granted that an R^2 of 0.97 using number of years as the independent variable explains 97% of the variation in the FCF, but wouldnt you be better off using a variable like cash flow from operations?

By: George

George — Mon, 24 Mar 2008 10:29:09 +0000

I used free cash flow and year as the dependent and independent variables, respectively.

By: Vivek

Vivek — Mon, 24 Mar 2008 10:03:58 +0000

What variables did you use as the dependent and independent variables?

By: George

George — Wed, 12 Mar 2008 13:27:45 +0000

Faro, I’m not sure how analyzing free cash flows is not value investing. All I’m really doing is saying that using a simple linear trend is not a bad way to analyze free cash flows. I used the statistics to test my theory. I might be using formulas but so far none of them are for making buy or sell decisions. I’ve only used this to find consistent cash generating firms for further research.

By: Faro Research

Faro Research — Sat, 01 Mar 2008 04:07:40 +0000

Is this really a value site, R², linear regression? The more formulaic you get the more you lose.

By: George

George — Sat, 01 Mar 2008 03:10:32 +0000

I used the process described at this University of Illinois at Chicago econometrics course excersize. A similar process is also described in my old Basic Econometrics text by Gujarati. Basically you have to manually calculate the TSS (total sum of squares) and RSS (residual sum of squares) using the non transformed exponential curve equation. I took the antilog of the slope times X plus the intercept and used that when calculating the residual sum of squares.

By: John

John — Sat, 01 Mar 2008 02:40:35 +0000

“For the exponential growth, I had to create an R² that was comparable to the R² of the linear functional form called a quasi r-squared. This is critical because the normal R² value for the log linear transformed exponential growth models often underestimates the prediction error in the most recent years of growth because it fails to capture the overestimate of growth in the most current years of data since FCF is still in a log scale. The results are summarized in the table below.”

I have never heard of this criticism before. Could you post the formula that you used so I may understand your point better? Thanks.

By: Mark Perkins

Mark Perkins — Sat, 01 Mar 2008 01:24:52 +0000

Would you happen to have a simple excel spreadsheet to calculate yearly and total returns?