As Fed Fights Inflation, Free Cash Flow Surfaces As Valuable Metric

One of the three newest members of the Federal Reserve board of governors said that high inflation was his biggest concern and that the Federal Open Market Committee is determined to bring inflation back down to 2%. That’s putting a spotlight on free cash flow as a metric to evaluate corporate profitability.

In a speech a conference organized by the Federal Reserve Banks of Atlanta, Dallas, and Richmond, Philip Jefferson said that while the “labor market remains strong … inflation remains elevated, and this is the problem that concerns me most.”

Jefferson also noted that “restoring price stability may take some time and will likely entail a period of below-trend growth.” However, he assured conference attendees that the FOMC is “resolute that we will bring inflation back down to 2%.”

“The full effects of monetary policy take time, but in my brief time on the Federal Open Market Committee, we have acted boldly to address rising inflation, and we are committed to taking the further steps necessary,” he added.

Jefferson was sworn into office in May, just in time for the Fed to announce three interest rate hikes of 75 basis points, bringing its benchmark interest rate from a range of 3% to 3.25%. The U.S. central bank has signaled that it will continue raising rates at a hawkish clip until it reaches a “terminal” rate between 4.5% and 4.75%.

With the Fed likely to continue raising interest rates, the liquidity squeeze already occurring in markets will be exacerbated. So, investors may want to reinforce their portfolios by targeting companies with solid free cash flow characteristics.

Free cash flow is the cash left over after a company has paid expenses, interest, taxes, and long-term investments. It is used to buy back stocks, pay dividends, or participate in mergers and acquisitions.

FCF Advisors specializes in free cash flow investment strategies, primarily through its Free Cash Flow Quality Model. They have been focused on this factor since 2011 and are specialized in multi-factor fundamental analysis grounded in decades of research. Two exchange traded funds that FCF Advisors offers include the FCF US Quality ETF (TTAC) and the FCF International Quality ETF (TTAI).

TTAC aims to outperform the Russell 3000 through a fundamentals-driven investment process that selects about 150 stocks based on free cash flow strength. Its holdings are then weighted by a modified market-cap log transformation, allowing increased exposure to companies with the strongest proprietary rankings.

TTAI, meanwhile, aims to outperform the MSCI All Country World Index ex the U.S. through an active investment process. A quant model is used to rank stocks based on proprietary measures of free cash flow. Highly leveraged firms that incur debt to buy back shares, or don’t satisfy ESG criteria, are screened out. Roughly 150 of the highest-ranked stocks are selected and then weighted on a modified market-cap basis that factors in free cash flow and log transformation.

Both ETF portfolios will also be rated with an ESG score, excluding companies with low ESG ratings. Firms with an extreme rise in shares count and increase in leverage are excluded.

For more news, information, and strategy, visit the Free Cash Flow Channel.