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More Cash Is Better

December 2013

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A critical, fundamental characteristic of the companies we invest in is attractive levels and faster growing free cash flow. We define free cash flow (FCF) as net cash flow from operations (CFFO) minus capital expenditures (Cap-Ex). In other words, free cash flow is the excess cash a company’s management has available after making the needed investments in property, plants and equipment.

The more free cash flow available and the faster it grows over time, the more flexibility a company’s management has to increase shareholder value.

Faster Growing

Free Cash Flow in <em>Capital's</em> Composite 10-Year History

The chart above presents the net cash from operations (blue bars), capital expenditures (red line) and the resulting free cash flow (green line) for the Capital composite (as of 9/30/13). Over the last 10 years, CFFO and FCF have increased at a double-digit growth rate and Cap-Ex has increased at a single-digit rate. In comparison, the typical company in the S&P 500 index for the same period experienced high-single-digit growth in CFFO,FCF and Cap-Ex.

In addition to growing cash flow faster, we seek companies that generate a higher level of free cash flow. Again, the more free cash flow available the more flexibility there is to enhance shareholder value.

A Greater Amount Available

Net Cash Flow Converted to Free Cash Flow <em>Capital</em> Composite 10-Year History

In this chart, we present the percentage of net cash flow from operations for the Capital composite (as of 9/30/13) that is converted to free cash flow. Over the last decade, these companies have averaged 80% conversion. Said another way, this group of companies on average only uses about 20% of net cash flow from operations for capital expenditures. For the S&P 500 companies, the average free cash flow as a percent of net cash flow from operations for the same period has been about 60%.

In other words, the companies in our portfolio, on average, need 20% less cash flow from operations to fund their capital requirements than that of a typical company in the S&P 500. This “freer” cash can be put to use in value-enhancing ways.

Uses of Free Cash Flow

How a company’s management chooses to invest free cash flows will vary from company to company and industry to industry. The main uses would include:
• Dividends
• Mergers and Acquisitions
• Share repurchases
• Debt reduction
In our opinion, the more free cash a company generates the more flexibility a company’s management has to pursue any or all of these activities.

Making decisions on how to allocate their available capital is the single greatest responsibility of any management team.

Having a faster growing and higher level of free cash flow gives a company’s management more options and should give them a better opportunity to enhance shareholder value over time.

We remain focused on understanding the current trend in fundamentals because it gives us the best probability for success.