Quant Concepts: Go with the Cash Flow

Companies with room to breathe are strong in both up and down markets, Emily Halverson-Duncan illustrates

Emily Halverson-Duncan 3 July, 2020 | 1:29AM
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Emily Halverson-Duncan: Welcome to Quant Concepts' virtual office edition. Examining a company's cash flow or lack thereof can give a good indication as to the status of their financial health. Excess cash flow is indicative of a company's ability to take on new projects, to pay dividends to their shareholders, to reduce debt and so on. Whereas a lack of cash flow makes any one of these items much more difficult to achieve. Today's strategy is looking for U.S. companies' strong cash flow compared to their peers. So, let's take a look.

Jumping into our U.S. CPMS, first off, we're going to go through and rank our universe of stocks. So, our stock universe here contains the 2,087 names in the CPMS U.S. database. In this first step, we're going to organize those in an order where we can see what stocks we like better than others.

So, some of the factors that we're going to look at – free cash flow yield, and we're wanting to see higher values for that metric. Latest trailing free cash flow, and again, higher values are preferred. Quarterly cash flow momentum is looking at the quarter-over-quarter growth of their cash flow and we want to see that increase. A 5-year beta, that's a measure of sensitivity or a measure or risk and we're wanting to see lower values of that.

Once we've organized our universe, we're going to go ahead and screen out the stocks that we don't want to own. So, a few of the screens that we're using here – that free cash flow yield, we want that to be in the top third of peers and today it has a value of 5.56% or higher. Market cap – we're just trying to get rid of any of those low liquidity names and low smaller cap names in here. So, we're setting it to be in the top third of peers which today has a value of $5.8 billion or higher. Free cash flow to debt, that's another risk metric but still taking into account from a cash flow perspective – we want that to be in the top third of peers. So, we're wanting to have more free cash flow on the books compared to the debt. And today, that has a value of 22.94 times or higher. And then, that quarterly cash flow momentum that we looked at, we want that to be greater than or equal to 5%, meaning that they are growing their cash flow at a rate of 5% when comparing quarter-over-quarter.

On the sell side, some sell conditions we're going to look at – that free cash flow yield, if it falls in the bottom, say, roughly half of peers, which is the value of 1.63% or lower, then we would sell the stock out of the model. Free cash flow to debt – same thing, if it falls into the bottom half of peers, which is about 4.5 times or below, we're going to sell it out of the model. And then, lastly, quarterly cash flow momentum if it's declining any more than 4%, so more than negative 4%, we are going to get rid of that stock and purchase something else.

In terms of how the model has performed over the long-term, we can take a look at our back test. So, we can see here across that full timeframe of April 2004 to May 2020, the back test has returned 12% which is an outperformance over the S&P 500 of about 3.2%. Turnover is on the higher side here at 120%. But keep in mind, what that's meaning is on a 10-stock portfolio, that would be about 12 trades per year. So, it's a bit higher than some of the models we've looked at in the past. But really on that stance you could look at that as roughly one trade per month. There's going to be some years, that would be a bit higher and some years, that would be a bit lower.

In terms of some of the metrics that we like to look at – downside deviation looks at the volatility of negative returns, for the strategy, it's 11.3% compared to the benchmark of 9.9%. So, we're seeing a touch more volatility here on the strategy compared to the benchmark. And then, lastly, my favorite green and blue chart, so looking at how the model has performed in both up and down markets. In up markets the model has outperformed 61% of the time. So, indicating that it actually does pretty when the market is trending upward. And then, in down markets, it's outperformed about 47% of the time or just under half. So, while this model has outperformed over the long-term, you can see that there will be some volatility you'd still experience; however, it still has compounded into a pretty good outperformance over the S&P 500.

For Morningstar, I'm Emily Halverson-Duncan.

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Emily Halverson-Duncan  Emily is Director, CPMS Sales at Morningstar

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