An exchange traded fund strategy that specifically targets companies with attractive free-cash-flow could help limit drawdowns during market sell-offs and capture high returns during market bull runs.
The Merrill Lynch US Quantitative Strategy team found a portfolio built on free cash flow producing companies offered an investor the highest return and the fewest periods of negative returns, according to a Pacer ETFs research note.
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. The ability to generate a high free cash flow yield indicates a company is producing more cash than it needs to run the business, which can then be invested in growth opportunities.
Free cash flow producing companies generally have three defining characteristics – they are productive, reliable and self sufficient. The companies generate more cash flow then they spend, which allows them to grow without external financing. The free cash flow is sturdy measure of profitability than earnings, which are subject to manipulation and accounting assumptions. Lastly, as the companies are less reliant on capital markets for financing, they won’t dilute their issued company stocks.