Fructivore Investments

In my last article at seekingalpha.com on the dramatically low price of Best Buy (BBY), it was pointed out to me by a commenter that I have a nonstandard definition of operating cash flow. Specifically, when calculating a company’s operating cash flow, and consequently free cash flow, I ignore changes in working capital as a source or sink of cash.

I do not recall consciously choosing to ignore this category of the cash flow statement. Obviously ignoring versus not ignoring it can produce significant divergence in a company’s free cash flow. But, having had this tendency pointed out to me, I naturally examined the literature and my own investment philosophy to determine whether my view of changes in working capital is reasonable. I concluded that changes in working capital can often, but not always, be set aside.

The first reason why changes in working capital can be set aside is that my goal in performing a valuation is to arrive at a reasonably conservative estimate of a company’s earnings power, and changes in working capital are often temporary. An increase in inventory in one quarter can be offset by the sale of inventory in the next quarter, and payables incurred in one year may be paid off in the next. In consequence, we have not lost the cash invested into working capital in the first period, but only the interest on it. By according too much attention to changes in working capital, the earnings power of a company is made to look more volatile than it is. Of course, Ben Graham’s advice in his Security Analysis is to perform a multi-year analysis rather than placing undue emphasis on the performance of a single year or single quarter. This may resolve this matter without recourse to more complicated modes of analysis.

Even without taking reversibility of working capital changes into account, some categories of changes in working capital are inherently nonrecurring. Changes in working capital in one year are often in no way tied to the changes that occurred last year, or will occur next year. If, say, a retailer makes a deal with its suppliers that it can buy inventory on 90 days’ credit instead of 60 days’, this will produce a dramatic influx of cash in the form of increased payables. However, it would be unwise to infer from this that in the next accounting period, the company will be able to expand its payables to 120 days. Therefore, this source of cash flow would be ignored in calculating a company’s long term earnings power (although it would be taken into account in calculating a firm’s excess cash, obviously).

The second reason I choose to set aside changes in working capital is that working capital is not consumed in the manner that fixed capital is. If, for example, a business invests $3 million in a piece of machinery that has a lifespan of three years, then at the expiration of three years the business is left with a pile of scrap metal. If, however, a business invests $3 million in inventory and receivables, and spends three years selling inventory, collecting receivables, paying down payables, and (hopefully) having cash left over, then at the end of the three years it should have $3 million in working capital, apart from the usual vagaries of obsolete inventory, bad debts, and so on. Working capital, then, if managed correctly, does not wear out. That is why there is generally no depreciation allowance given for it. And, as I said above, an increase in working capital in one year does not imply that there will necessarily be a similar increase in working capital in any future years. This is not true for fixed capital, which requires continuous replenishment. That is why I count excess depreciation as a source of cash flow, and capital spending in excess of depreciation as a cash sink.

This brings me to my third reason to set aside changes in working capital: the distinction between maintenance and growth capital. Ben Graham reminds us that a company’s earnings are only true profits if the expenditures necessary to maintain the company’s earnings power have been made; otherwise a company is merely liquidating itself in slow motion. I have always been skeptical of projecting a company’s growth rate; I attempt to find companies that would be attractively priced even if there is no growth at all, or even shrinkage. This conservatism leads me to assume that all fixed capital investments are required to maintain the current level of earnings power, not to produce growth in future periods.

However, the argument for this assumption is weaker in the case of working capital. Despite the theoretical nonrecurrence of changes in working capital, it would be unrealistic to expect a business with $500 million in sales to have the same level of working capital as it did when sales were $50 million. As a result, we would expect such a company to have made significant investments in working capital over the years, which would constitute a cash sink in the accounting periods leading up to it. This cannot be explained away as being potentially reversible in future periods; even if there is volatility in levels of working capital from the beginning to the end of this process, there is still an inevitable upward drift.

However, as we are told in Mulford & Comiskey’s Creative Cash Flow Reporting, a valuable resource that focuses on ferreting out a company’s sustainable cash flow from its earnings and cash flow statements, a company’s working capital is expected to rise and fall alongside the size of a company’s business. Therefore, ceteris paribus it will be increasing for growing companies, flat for stable companies, and declining for shrinking companies. In other words, investments in, and drawdowns of, working capital would be generally associated with increases and decreases in a firm’s level of activity. I.e. investment in working capital is growth capital.

This conclusion, which I think is the strongest defense of setting aside changes in working capital, also allows us to zero in on the key vulnerability of my approach. If there is an increase in working capital that is not associated with an increase in a business’s level of operations, but is instead due to lower margins, decreasing efficiency, and so forth, then ignoring changes in working capital can lead an investor into making fatal mistakes. However, I would say that more often than not this occurrence can be identified by examination of a company’s financial statements, in areas such as profit margins and movements in incremental sales versus incremental working capital although the latter should probably be smoothed over a number of years.

As a result, I can say that my approach towards setting side changes in working capital when calculating a business’s free cash flow, although nonstandard, does not generally introduce fatal inaccuracies in my estimates of future earnings power. Provided that a company does not invest in additional working capital inefficiently, investments in working capital would generally fall under the category of nonrecurring, or growth capital, both of which would fall out of our estimation of theoretical long term earnings power. And having performed this investigation in my investment methods, I have found a significant investment metric, incremental sales versus incremental working capital, to examine in greater details in future valuations when changes in working capital have been significant.

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Investing by grocca