Accounting practices can present a distorted picture of a publicly traded company’s profitability. Plus, earnings reports tend to be historically backward-looking. Therefore, free cash flow can be a more reliable metric than earnings to determine how profitable a company is.
Simply put, free cash flow is the cash a company generates after its cash outflows to pay expenses or support operations. Bob Shea, CEO & CIO of FCF Advisors, told VettaFi that his firm believes that while “GAAP earnings have significant disadvantages,” and “accounting practices allow a lot of leeway and discretion to management… The ability to manipulate and distort free cash flow is a lot more difficult than with earnings.”
“Free cash flow is so important right now, given that the allocation environment has gotten exponentially more difficult in 2022,” Shea said. “Cohorts have never seen an environment like this. In a difficult environment, people want to make sure they understand what they own.”
Shea also pointed out that FCF Advisors focuses on free cash flow profitability, which is operating cash flow after capital expenditures, rather than free cash flow yield, which compares free cash flow and market cap.
FCF Advisors specializes in free cash flow investment strategies, primarily through its Free Cash Flow Quality Model. They have been focused on free cash flow factors since 2011 and are specialized in multi-factor fundamental analysis grounded in decades of research. Two exchange traded funds that FCF Advisors offer that specialize in free cash flow 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 free cash flow 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.
“We’ve redefined what it means to be a quality company through the lens of free cash flow profitability,” Shea added.
For more news, information, and strategy, visit the Free Cash Flow Channel.