Investors should consider a disciplined and consistent investment exchange traded fund strategy driven by quantitative models to hone in on high-quality companies exhibiting high free cash flows.
In the recent webcast, When Markets Wobble, Cash Remains King: Free Cash Flow Investing, Bob Shea, CEO and chief investment officer of FCF Advisors, noted that while inflation has been coming down, it remains meaningfully above the Federal Reserve’s 2% target.
Meanwhile, recession fears are receding. Shea pointed out that the Citi US Economic Surprise Index, which measures data surprises relative to market expectations, has slightly improved to -23.5 by mid-August, compared to the -78.7 low of late June. Nevertheless, the negative reading means that data releases have been worse than expected.
Markets can no longer expect accommodative measures to fuel the next leg of growth as global central banks are rolling back quantitative easing measures in face of record high inflation.
Looking ahead, the markets are growing less bearish, but sentiment remains down. For instance, AAII Sentiment Survey offers insight into the opinions of individual investors by asking them their thoughts on where the market is heading in the next six months and has been doing so since 1987. About 46.5% of AAII members feel the stock market will have a bearish tilt for the months ahead, compared to the historical average of 30.5% with a bearish sentiment.
Many investors remain defensive with large cash hoards. For instance, institutional cash levels remain elevated, with average cash holdings in July 2022 at their highest since the dotcom-era bust.
In this type of uncertain market environment, Shea argued that investors should focus on quality companies to better weather the storms while keeping exposure to potential upside opportunities.
“We are the experts in free cash flow analytics – we believe the surest path to uncovering real quality,” Shea said.
FCF Advisors is the leader in free cash flow investment strategies — primarily through the Free Cash Flow Quality Model (FCFQM). They have been focused on free cash flow factors since 2011 and are specialized in multi-factor fundamental analysis grounded in decades of research. Investors can access their expertise through ETFs, such as the FCF US Quality ETF (TTAC) and the FCF International Quality ETF (TTAI).
“Simply put, we believe quality factors based on free cash flow inputs deliver better results,” Shea added.
“Free Cash Flow profitability can deliver higher returns with less volatility.”
The free cash flow profitability indicator has provided greater historical excess returns compared to other quality indicators, such as a change in asset turnover, debt to equity, gross margin, operation ROA, return on assets, and earnings persistence. Additionally, the free cash flow profitability indicator has done so with greater volatility reduction than many other quality indicators as well.
“Stocks with strong free cash flow profitability outperform the market in almost every sector,” Vince (Qijun) Chen, portfolio manager and senior quantitative analyst at FCF Advisors, said.
Chen argued that traditional approaches, dependent on earnings data, suffer significant disadvantages when compared to the free cash flow factor that provides more reliable results. An earnings-based approach is exposed to accepted accounting practices that allow management a great deal of discretion when reporting company earnings: are likely to select historically profitable and stable companies rather than those that will outperform in the future, and tends to result in low-beta portfolios that can underperform when markets are buoyant.
“We believe our Free Cash Flow Quality Model (FCFQM) offers a more reliable path to selecting winners,” Chen said.
Chen explained that their model’s inputs are based on free cash flow which does not suffer from the uncertainty of company earnings; seeks to predict stocks with strong profitability that will endure, not just “safe bets” that performed in the past; and selects for strong and sustainable profitability – selected stocks tend to outperform throughout the cycle. Additionally, FCFQM aims to identify Quality companies with strong and sustainable profitability that will consistently outperform the market.
Financial advisors who are interested in learning more about high-quality investment ideas can watch the webcast here on demand.