As companies prepare for a recession that we may very well already be in, it is important to understand what free cash flow (FCF) is and how it protects companies in challenging times.
Free cash flow is simply the cash a company generates after its cash outflows, such as maintenance of capital assets. FCF represents the cash that a company has ready and available to use on repaying creditors or sending out dividends to investors. As such, it is a far more robust measurement than simply looking at raw earnings.
VettaFi head of research Todd Rosenbluth said that “given the market volatility in 2022, advisors have sought out companies with strong free cash flow generation as they provide relative stability.”
If a company was consistently pulling in $100K per year it might look healthy. But if their FCF could be steadily dropping. Perhaps vendors are demanding faster and more frequent payments or customers have delayed payments. The FCF could be revealing a structural weakness in the company that a simple net income metric would be effectively masking.
Of course, FCF dips don’t necessarily indicate a company is in trouble. It is possible that they purchased new equipment or had extra capital expenditures for one year to shore up their ability to meet demand or to grow the business. This is why technical analysts will focus on the trend of FCF instead of the absolute value.
Still, it is a useful measurement to take stock of a company’s fundamentals. ETFs such as the FCF US Quality ETF (TTAC) and the FCF International Quality ETF (TTAI) both invest in companies that have strong free cash flow characteristics, as those companies tend to be well-positioned to weather economic storms and survive rough markets. Both funds are actively managed. Rosenbluth notes that “advisors have turned to actively managed strategies in 2022 to benefit from the flexible approaches they offer. These funds take a fundamental approach to identify high-quality companies trading at attractive levels.”
For more news, information, and strategy, visit the Free Cash Flow Channel.