Free cash flow now emerging as key investment parameter

Investors are beginning to see free cash flow of companies as a key indicator of future profitability and investment opportunities, money managers say.

Free cash flow — a measure of a company's liquidity — is increasingly being looked at by investors compared to traditional measures of equity return prediction such as price-to-book or price-to-earnings ratios.

How companies are deploying free cash is becoming a much more reliable metric to evaluate equities. Industry sources said historical analysis of a company's free cash flow is a more dependable guide to profitability and stock price valuation over a five- to 10-year term than forecasts produced by sell-side brokers and company executives.

In addition, the rise of cash-rich companies make a traditional stock valuation approach flawed because companies can end up with negative earnings but positive free cash flow and vice versa.

Bob Collie, head of research at Willis Towers Watson PLC's Thinking Ahead Institute in London, said too much free cash flow traditionally "wasn't a problem that a lot of companies had. But it has now become a key to the strategy for these (investee) companies. In theory, this could have always been something that needed to be analyzed but the reason it is a big deal now is because some companies are extremely cash rich."

Cash-rich companies juggle different purposes for their extra cash flow, including dividends or mergers and acquisitions, which could alter how investors view them in their portfolios. Increasingly, these companies operate asset-light business models and won't require additional cash to support the manufacturing of goods, for example.

These companies also are less dependent on capital market financing or less susceptible to macroeconomic forces because they have the resources to ride out turbulence.

For example, "Apple and Google traded at attractive free-cash-flow-yield levels in 2015 and 2016 and it took the market a while to recognize the sustainability of these cash flows," said Lode Devlaminck, managing director, equities at DuPont Capital Management Corp., Wilmington, Del., which runs $28.7 bill-ion in assets on behalf of the DuPont company pension plans and other institutional investors.

These developments affect the dynamic of the relationship between company management and investors, according to sources. "The fact that some companies are able to generate enough money to become self-sustaining without the capital market has implications to (the) accountability of management," Mr. Collie said.

Managers said they are engaging with existing portfolio companies with the intent to understand how they are reinvesting their free cash flow.

"From a strategic point of view, (free cash flow) has more implications for the capital structure of companies and … where they get the money from, which goes on to accountability because if you have a management which has all the cash it needs, it doesn't need to worry what the (shareholders) think about it," Mr. Collie said.

Mr. Devlaminck added it is important to monitor companies' capital allocation and how they invest their free cash flow. But not every traditional style strategy adopts a free-cash-flow lens into stock analysis, according to sources.

Mr. Devlaminck added: "We noticed that price-to-book has become a more cyclical and beta-driven valuation metric, compared to free cash flow. We have become much more explicit about studying and analyzing the capital allocation policies of the companies we invest in."

"There are a bunch of companies you have to avoid because their actions, like overpaying for acquisitions, tend to be value-destructive," he added.

Sources said equity market valuation is high relative to historic levels, especially in the U.S. because of extreme valuations being afforded to many stocks of companies that are promising aggressive earnings growth.

Because business models and economic cycles have changed, investors need to consider whether the companies require a large amount of investment to produce goods or services, sources said. "Asset-light business models tend to generate higher returns and free cash flow," Mr. Devlaminck added. While the market is reasonably good at pricing the free-cash-flow generation of a company, the reinvestment of this cash flow can be a source of mispricing, he said.

Owen Thorne, investment manager at the £9 billion ($11.8 billion) Merseyside Pension Fund, Liverpool, England, agreed that "free cash flow is another tool to carry out valuation. ... As a long-term investor, we should be looking how we can benefit from the business cycle rather than the short term." Mr. Thorne thinks that financial analysis "promises a wide range of data points that are quite shallow in terms of the underlying drivers, and different ways of valuation is a benefit to longer-term participants in the market." He declined to go into further details about Merseyside's approach.

"Stocks that are cheap on free cash flow tend to do better than stocks that are cheap just on earnings. Investors increasingly recognize this," said Ira Carnahan, portfolio specialist in the U.S. equity division at T. Rowe Price Group Inc., Chevy Chase, Md.

"Earnings are easier to manipulate than cash flow. Reported earnings are an accounting construct. Free cash flow, on the other hand, is money that can actually be returned to investors. Looking at free cash flow helps us assess the underlying quality of reported earnings," he added.

Samantha Gleave, London-based co-manager of Liontrust Asset Management PLC's cash-flow-solution team for the Liontrust European Growth, Liontrust Global Income, Liontrust GF European Smaller Companies and Liontrust GF European Strategic Equity funds with £984 million in assets under management, said: "Cash flow is the most important determinant of shareholder returns. While companies can manipulate earnings, cash doesn't lie.

"Investors in our funds know that our investment philosophy is based on taking advantage of the mistakes people make when forecasting. In our view, mispricing of stocks often stems from overconfidence in forecasts of future profitability made by company managers and sell-side brokers, which often turn out to be unreliable," Ms. Gleave said.

With interest rates increasing and the withdrawal of quantitative easing by central banks looming globally, investors are looking for companies with a high reinvestment rate of return from free cash flow that would help offset a capital loss when the market declines. Sources said companies can maximize returns by allocating capital well.

Junichi Takayama, investment director at Nikko Asset Management in Tokyo, said: "Corporates are enjoying a record cash balance on the back of a strong recovery in earnings, as the global economy continues to emerge from the financial crisis. This, combined with current low-dividend payouts, means there is plenty of room to return more, as corporate governance practices improve" in Japan.

He added: "We believe sustainable dividend growth is a key driver of share price, and for us to be excited about a stock, it must be a quality business with efficient capital management and solid financials. Scalable businesses are also attractive, as they improve capital efficiency by producing each unit using less capital, leaving more cash for shareholders. And finally, companies with less financial leverage have more room to distribute more to shareholders."