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It’s often said that “turnover is vanity, profit is sanity, cash is a reality.” Experienced investors understand that companies can play around within the confines of accounting standards to make their top lines appear more attractive than they really are. Profits, meanwhile, are harder to manipulate and cash flow is nearly impossible.
This is why legendary investors like Warren Buffett prefer to focus on a company’s cash flows to judge its intrinsic value. However, it’s easy to overlook this metric, because it doesn’t get much mainstream attention and requires a closer look at the company’s balance sheet to figure out.
Fortunately, I took a closer look recently and found two Canadian stocks that had lucrative cash flow yields and an attractive rate of long-term growth in this crucial metric.
TransAlta
Wholesale electricity supplier TransAlta (TSX:TA)(NYSE:TAC) isn’t a particularly popular stock, either for growth investors or income seekers. The stock currently offers a dividend yield of just 1.8%, which is far below the stock market average. Meanwhile, the stock price has flatlined over the past five years.
Nevertheless, the company seems to be generating cash flows at an excellent pace. Free cash flow, adjusted for leverage, over the past 12 months was $226 million, which implies a cash flow yield of roughly 9.2% per share at the current market price.
Free cash flow has expanded 10-fold over the past three years, while the stock price stayed suppressed. Unsurprisingly, the stock is undervalued, trading at just 1.25 times book value per share.
The company’s exposure to green energy subsidiary TransAlta Renewables is another reason I like this stock. It seems to be in a much better position than the market seems to believe at the moment.
Aritzia
Unlike TransAlta, fashion giant Aritzia (TSX:ATZ) isn’t being underestimated by Bay Street. The stock is trading well above its listing price in 2016 and has doubled in the past two years alone.
Despite this recent spike in market capitalization, the stock doesn’t seem overvalued when you consider its strong fundamentals. It’s currently trading at 30 times trailing earnings and 22 times forward earnings per share. The firm also generated $104.7 million in leverage-adjusted free cash flow (FCF) over the past 12 months. That implies a cash flow yield of 4%.
Cash flow seems to be expanding rapidly. FCF per share has tripled in the last three years, compounding at an annual rate of 45.3% since the end of 2016. This pace of growth doesn’t seem to be priced into the stock yet, making it an excellent opportunity for long-term investors seeking a robust addition to their portfolio.
Bottom line
For professional investors like Warren Buffett, cash flow is perhaps the most critical valuation metric. Steady and expanding cash flows are a sign that the company has a competitive advantage and effective management at the helm.
Luxury retailer Aritizia and wholesale electricity supplier TransAlta both seem to have expanding cash flows and attractive rates of return on equity, which makes them prime candidates for a long-term value investor’s portfolio.
