Investing With The House

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By Trim Tabs :

With this article, Seeking Alpha introduces Charles Biderman, the founder of TrimTabs Investment Research. Founded in 1990, TrimTabs has been tracking flows into and out of US stocks, mutual funds and ETFs in an effort to measure quantitatively the supply of and demand for shares of stock and the money available for investment. Charles welcomes your comments and feedback.

I am often asked by individual investors, what is the best way to invest for the long term?

My answer is to invest with the house. In all markets the house has an advantage over the players. No market would exist if the house did not have an edge. In the stock market, the house is represented by the public companies. They know much more than investors about what's really going on at their companies. They have an obvious edge.

What I have discovered watching the markets for over 40 years is that when companies are optimistic about their future, they reduce the number of shares outstanding. When companies are pessimistic about their future, they typically sell more shares to raise cash.

To invest with the house, buy shares in companies where free cash flow is growing, the number of shares outstanding is shrinking, and where the debt to equity ratio is not growing.

You can also invest with the house by shorting a portfolio of companies where free cash flow is negative, the float of shares is growing due to secondary share offerings and/or the company is borrowing more money.

Some Definitions: Free Cash Flow & Trading Float

Free cash flow is the amount of cash left over after paying all expenses, research and development costs, capital expenditures, and adjusting for changes in working capital and depreciation and amortization.

The trading float of shares shrinks when companies buy back in total more shares then they sell. The trading float grows when companies sell and/or issue more shares than they buy.

To fully understand float change and free cash flow, let's use as an example a hypothetical company, XYZ Inc.

XYZ Inc has one hundred million shares outstanding, trading at $100 per share. The overall market cap therefore is $10 billion. Let's assume that XYZ Inc. generates $1 billion annually in free cash flow, an amount equal to 10% of the $10 billion market cap. Then let's assume that XYZ Inc. uses $600 million of that $1 billion to shrink the float. XYZ Inc. could buy back sixty million shares, or 6% of the outstanding, for $600 million and still end the year with an extra $400 million in cash.

After the six million share float shrink, there are only 94 million shares left. If the stock price stayed the same $100 per share, that would mean that XYZ Inc is now only worth $9.4 billion. Yet XYZ is still generating $1 billion annually in free cash flow, and the only thing has changed is the number of shares is smaller. Therefore, it would be logical to expect the value of the remaining shares to rise by at least 6%, to $106 and change, which, times 94 million shares, leaves the market cap remaining at $10 billion.

For some perspective, there are currently only 750 companies in the Russell 3000 index that are shrinking their float, while over 2,200 companies are currently growing their float. Among the companies shrinking their floats are Amgen ( AMGN ), Pepsi ( PEP ), DirecTV ( DTV ), Wyndham Worldwide ( WYN ), and Plantronics ( PLT ) (see list below).

The healthy dynamic of companies growing cash and using that cash to reduce to the number of shares outstanding can work to provide support for a higher share price in all markets - bull (1993-2000; 2003-2007) bear (2001-2002; 2008-2009) and in between. The reason: the company is a consistent buyer regardless of the market downturn. Similarly, the shares of a company using a market rise to expand their float may very well appreciate along with the broad market, but at a slower pace than the cash-flow rich companies.

Currently, you could make up a portfolio comprised of the top 100 companies that are growing their free cash flow, shrinking their share float the most, and not borrowing to buy those shares: This group of stocks averages a free cash flow yield of 10.5%, are shrinking their trading float by over 8% annually, wand have a P/E ratio of 13.4 times earnings, and an average market cap of $16.2 billion. The full list is below:

Ticker

COMPANY NAME

AAN

AARON'S INC

ADTN

ADTRAN

AAP

ADVANCE AUTO PARK

AMG

AFFILIATED MANAGERS GROUP

AKAM

AKAMAI TECHNOLOGIES

AMGN

AMGE

ACOM

ANCESTRY.COM

APOL

APOLLO GROUP-A

AZO

AUTOZONE

AVT

AVNET

BBBY

BED BATH & BEYOND

BBY

BEST BUY CO

BIG

BIG LOTS

BMC

BMC SOFTWARE

SAM

BOSTON BEER

BPI

BRIDGEPOINT EDUCATION

EAT

BRINKER INTERNATIONAL

BKI

BUCKEYE TECH

CA

CA INC

CACI

CACI INTERNATIONAL

CPLA

CAPELLA EDUCATION

CBS

CBS

CELG

CELGENE

CRL

CHARLES RIVER LABORATORIES

CAKE

CHEESECAKE FACTORY

CSTR

COINSTAR

CMTL

COMTECH TELECOMMUNICATIONS

STZ

CONSTELLATION BRANDS

MCF

CONTANGO OIL & GAS

CPRT

COPART

EXBD

CORPORATE EXECUTIVE BOARD COMPANY

CXW

CORRECTIONS CORPORATION OF AMERICA

CY

CYPRESS SEMICONDUCTOR

DTV

DIRECTV

DLB

DOLBY LABORATORIES

DPZ

DOMINO'S PIZZA

UFS

DOMTAR

EXPE

EXPEDIA

ESRX

EXPRESS SCRIPTS

XOM

EXXON-MOBIL

FCFS

FIRST CASH FINANCIAL

FRX

FOREST LABORATORIES

GILD

GILEAD SCIENCES

GPN

GLOBAL PAYMENTS

GHL

GREENHILL & CO

GPI

GROUP 1 AUTOMOTIVE

HRS

HARRIS CORP

HLF

HERBALIFE LTD

HD

HOME DEPOT INC

IIVI

II-VI INC

IBM

INTERNATIONAL BUSINESS MACHINES

ESI

ITT EDUCATIONAL

JPM

JPMORGAN CHASE & CO

KLAC

KLA-TENCOR

LMT

LOCKHEED-MARTIN

LOW

LOWE'S COMPANIES

LSI

LSI

MANH

MANHATTAN ASSOCIATES

MRO

MARATHON OIL

MAR

MARRIOTT INTERNATIONAL

MA

MASTERCARD

MXIM

MAXIM INTEGRATED

MHS

MEDCO HEALTH SOLUTIONS

MW

MEN'S WEARHOUSE

MCRS

MICROS SYSTEMS

MCO

MOODY'S

MYGN

MYRIAD GENETICS

NVLS

NOVELLUS SYSTEMS

ORLY

O'REILLY AUTOMOTIVE

PEP

PEPSICO

PLT

PLANTRONICS

PRGS

PROGRESS SOFTWARE

PSSI

PSS WORLD MEDICAL

QLGC

QLOGIC

QSFT

QUEST SOFTWARE

SMG

SCOTTS MIRACLE-GROW COMPANY

SNI

SCRIPPS NETWORKS INTERACTIVE

SEIC

SEI INVESTMENTS COMPANY

STEC

STEC INC

SYMC

SYMANTEC

SYNA

SYNAPTICS

TECD

TECH DATA CORPORATION

TPX

TEMPUR-PEDIC INTERNATIONAL

TDC

TERADATA

MHP

THE MCGRAW-HILL COS

PGR

THE PROGRESSIVE CORPORATION

TW

TOWERS WATSON & CO.

VCI

VALASSIS COMMUNICATIONS

VECO

VEECO INSTRUMENT

VRSK

VERISK ANALYTICS

VPHM

VIROPHARMA

V

VISA INC

VPRT

VISTAPRINT LIMITED

WBC

WABCO HOLDINGS

WPI

WATSON PHARMACEUTICALS

WBMD

WEBMD HEALTH

WU

WESTERN UNION COMPANY

WRLD

WORLD ACCEPTANCE

WYN

WYNDHAM WORLDWIDE

XRTX

XYRATEX

Disclosures: http://trimtabs.com/global/etf_ttfs_disclosures.htm

A list of all specific recommendations made by the firm for the past year is available upon written request.

TrimTabs Asset Management, LLC, owns shares in each of the companies listed above in the portfolio of its actively managed ETF, the TrimTabs Float Shrink ETF (TTFS).

See also Cheap Natural Gas Is Creating Its Own Demand on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: AMGN , DTV , PEP , PLT , WYN

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