While investors and analysts pay a lot of attention to company earnings, these earnings reports don’t tell the whole story. Investors who are more risk-averse may want to focus on companies that generate free cash flow.
Free cash flow (FCF) is the cash a company generates after its cash outflows. It represents the cash that a company has ready and available to use on repaying creditors or sending out dividends to investors. FCF could be a better measurement of a company’s health than its raw earnings.
For example, if a company was consistently pulling in $10 million per year, it might look healthy and profitable. However, if its FCF was steadily dropping, that could indicate some structural rot within the firm, which could be masked from its seemingly strong net income.
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.”
FCF directly affects share price. Uber’s share price rose after reporting free cash flow of $382 million in the three months to the end of June, marking its first cash flow positive quarter ever. Meanwhile, AT&T’s stock dropped after lowering its full-year free cash flow outlook. This is despite the telecom company adding more wireless postpaid phone subscribers than expected in the quarter that ended June 30.
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.
TTAC aims to outperform the Russell 3000 through a fundamentals-driven investment process that selects about 150 stocks based on free cash flow strength, according to its FactSet Analyst Report. Its holdings are then weighted by a modified market-cap log transformation, which allows for increased exposure to companies with the strongest proprietary free cash flow rankings.
After that, the portfolio will 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.
TTAI, meanwhile, aims to outperform the MSCI All Country World Index ex USA 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.
Rosenbluth added 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.