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Financial Industry Insights from Advisors Asset Management

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AAM Viewpoints — Go with the [Free Cash] Flow


 

In the year thus far, the majority of growth investments have spectacularly unraveled against the backdrop of persistently high inflation, and consequently, an abruptly hawkish Federal Reserve. Appropriately, the S&P 500 Pure Value Index is up nearly 6%, outperforming the S&P 500 by 18%, and its pure growth equivalent by 27% year-to-date ending 5/31/22.

S&P 500 Pure Value IndexSource: Bloomberg | Past performance is not indicative of future results.

The past extended period of near zero interest rates had heavily incentivized investments in growth companies, which are primarily evaluated through recent sales and earnings trajectories. Despite these companies having low or even negative current cash flows, their vows to improve cash flows further out into the future were an acceptable trade-off for investors while interest rates remained low.

However, as the path of interest rates moved swiftly higher this year, the tradeoff of current growth for distant future cash flows quickly became less attractive. Thus, pure growth stocks experienced meaningful price-to-free cash flow (P/FCF) multiple contraction from the start of the year. The multiple also contracted for the broader S&P 500 stocks, though less significantly, and remained stable for pure value stocks.

Price-to-Free Cash FlowSource: Bloomberg | Past performance is not indicative of future results.

While growth investors have largely been hyper-focused on sales and earnings to measure a company’s future growth potential, we feel they may not be the most suitable measures for growth going forward. Given the continued dynamics of rising inflation and interest rates, investors may be better guided by keeping an eye on free cash flow when repositioning for the new regime ahead.

Free cash flow represents cash remaining after covering all operational costs, business reinvestment activities, and financing activities such as dividend payments to shareholders. These activities are more informative in measuring a company’s future growth potential, as their ability to generate cash ultimately the source for investing in future growth opportunities and returning cash to shareholders through dividend payments. Moreover, a positive free cash flow position indicates financial health in excess of the aforementioned activities. Not only can these companies more reliably maintain their current dividend payments, but potentially increase them going forward.

Particularly in a prolonged environment of heightened levels of inflation and interest rates, we expect growth companies with already strained free cash flow positions to struggle to provide the returns they have provided in the past. When ranking S&P 500 Pure Growth Index constituents by P/FCF, the top 25% index constituents were on average down drastically more than the bottom 25%, revealing the relatively more defensive nature of stocks with less extended P/FCF multiples within the pure growth category.

S&P 500 Pure Growth IndexSource: Bloomberg | Past performance is not indicative of future results.

Furthermore, rising interest rates have the potential to increase existing debt burdens as payments towards debt may rise along the way. Consequently, there is likely to be a further strain on cash levels, leaving less cash to spare for future growth opportunities or to pay dividends.

By contrast, focusing on companies with relatively healthier free cash flows can help identify investments with more sustainable growth potential, as well as those that can more reliably return cash to shareholders. In an environment where growth sustainability is coming in question, and income becomes a larger driver of total returns, tethering portfolios to free cash flow has the potential to help you navigate the market rotation.

CRN: 2022-0603-10073 R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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