Risk appetite has returned to European equity markets. Is there a way to capture the rally of value stocks while mitigating risks across an unsettled region? Focusing on cash flows can make the difference.

Undervalued stocks have led the way in Europe’s recent risk rally. Since the US election through December 12, the MSCI Europe Value Index has outperformed the broad market by over 2.4%. That continues a trend we’ve seen this year, in which value stocks in Europe have advanced by over 5.5% in euro terms, outperforming the broad index by over 5%. This year’s turnaround has been dramatic following five difficult years during which pervasive risk aversion suppressed returns of riskier stocks with recovery potential.

Value Stocks with Less Volatility

Investors are still uneasy. With the region facing a series of major political risks in the coming months and Brexit a probable source of instability for years to come, bouts of market turbulence and renewed flights to safety are expected. But we believe there is a way to take advantage of the outperformance potential of cheap stocks without adding too much unwanted volatility. The key is to emphasize cash flows in both quantitative and fundamental tools for finding undervalued stocks, which can help protect portfolios during downturns and create smoother return patterns.

The first step is to adopt a broader set of measures for discovering value. Investors have traditionally relied heavily on valuation measures based on accounting earnings and book value to identify undervalued stocks. Over the long run, stocks that are cheap on these measures have indeed outperformed. But the performance of stocks with attractive price/earnings or price/book value can be erratic from year to year. Our research shows that focusing on cash flows to identify attractive valuations can smooth the pattern of returns.

Since the outbreak of the eurozone crisis in 2011, performance patterns for different value metrics have been inconsistent (Display). For each value metric, we compared the performance of the cheapest 20% of stocks in the European universe against the market. A positive number shows cheap stocks doing well.

European Equities

European Equities

Different return patterns reflected market conditions each year. In 2011, all the factors did poorly during a severe bout of risk aversion. In 2013, all the metrics did well as a value recovery gathered steam. But in the last three years, return patterns have been more complex. Stocks that were cheap based on accounting book value and earnings underperformed while, in contrast, stocks with strong but undervalued cash flows—identified by the price to free cash flow metric—outperformed significantly. In other words, leaning in to cash flow helped smooth a value investor’s pattern of returns.

Crucially, focusing on cash flows also helps mitigate losses in a downturn. Stocks with attractively valued cash flows capture almost as much of rising markets as stocks that are cheap based on book values and earnings. Yet in falling markets, stocks that are cheap on price/cash flow will capture much less of the downside than other valuation metrics (Display).

European Equities

Bringing Private Equity Techniques to Public Markets

Emphasizing cash flows is also central to successful fundamental company analysis. Accurately assessing the cash flows that companies will produce and understanding how company management will deploy that cash is key to identifying companies that are likely to provide attractive returns to investors.

Private equity companies provide an excellent example of how to effectively incorporate cash-flow analysis. Internal Rate of Return (IRR) techniques, which are commonly used in private equity, provide a helpful cash-based analytical framework for valuing a potential investment in public equities.

How is this done? The key is to base an IRR calculation on the assumption that the exit multiple an investor will receive on a company investment will be the same—or even lower—than the entry multiple at purchase. By doing so, we believe investors can identify companies that can provide superior return potential, even without the sort of multiple expansion that undervalued stocks typically enjoy in a value rally.

This approach is a great way to smooth the journey in a value portfolio. Using disciplined, cash flow– based IRR techniques in fundamental analysis can enable investors to profit from investing in undervalued stocks without excessive exposure to the inevitable ups and downs of the style cycle. We think this approach should be particularly valuable in helping investors get the most from undervalued stocks—without getting bruised by the effects of European political controversies that are likely to linger.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSC

Article by Tawhid Ali, Nelson Yu – Alliance Bernstein