Counting On Cash In Cloudy Equity Markets by David Dalgas, AllianceBernstein
Equity markets are digesting mixed signals in early 2015, from the divergence of monetary policies, shifting economic growth patterns and currency volatility. Instead of worrying about deciphering these trends, we think investors should focus on individual company cash flows in order to identify companies with strong long-term return potential.
The environment today is anything but simple. European markets have shot ahead, as quantitative easing, a falling euro and better growth prospects have fueled hopes that European company earnings are finally recovering. On the other hand, US companies have been hit by fears over the strength of the dollar and uncertainties about US economic growth. And emerging markets continue to show signs of weakness, from China to Brazil.
But these complexities seem much less daunting if you focus on a company’s cash flows to find your way. In our view, investors seeking to grow their wealth over the long term should concentrate on understanding the strength and stability of individual companies’ future returns. Understanding cash flows is central to this. Unlike accounting earnings, which are often misleading, we believe that cash flows provide a clear picture of a company’s underlying performance. Cash flow return on investment (CFROI), which measures the return produced by a company’s net cash flows over time, can be particularly helpful as a guide.
Three Reasons to Focus on Cash
CFROI may not be the most intuitive metric for investors. And it isn’t a standard component in an equity investor’s tool kit. Yet in our experience, high and stable CFROI has proved to be a good indicator of companies with defensible competitive advantages and an ability to deliver stronger risk-adjusted returns over time for three main reasons:
- Cash is transparent—Accounting indicators of a company’s performance can be misleading. For example, earnings can be inflated by accounting decisions on revenue recognition. But generally speaking, cash provides a reliable depiction of how a company is really doing. By stripping out noncash measures from a company’s reports, an investor can also effectively compare companies that aren’t subject to the same accounting systems, neutralizing items that may be distorted by accounting technicalities to create an apples-to-apples basis for evaluating similar companies in different jurisdictions.
- Noise is reduced—Cash-based metrics typically make it easier to assess the impact of short-term fluctuations in earnings caused by one-off events or seasonality in revenues.
- Returns are more likely to be sustainable—High and stable CFROI is usually a sign of a company that generates value consistently. In our view, companies like these typically have a strategically sound position, built, for example, on a powerful brand and a large scale in a business that is protected by a “strong moat.” In other words, there are high barriers to entry for competitors, so these companies have the potential to maintain superior investment returns through changing market conditions.
What does that mean today? Companies with asset-heavy business models and strong exposure to the economic cycle look unattractive through the CFROI lens—as they often do (Display). On the other hand, many specialized financial and technology companies, with strong franchises and asset-light models offer very good opportunities, in our view. Examples include payment networks, such as Visa, and exchanges, such as CME Group (the Chicago Mercantile Exchange).
In fact, despite the underperformance of US markets this year, we continue to find many US companies with strong cash flows that indicate an attractive return potential, for example, in the health management industry. Among European companies, cash-flow characteristics are more compelling today among companies with strong consumer franchises, often global in their reach.
Of course, CFROI isn’t a crystal ball. Historical cash-flow numbers provide limited insight into the factors that influence future cash flows. So, to be effective, a cash-flow analysis must be coupled with a rigorous view of valuation based on a thorough analysis of a company’s business model, financial position and competitive environment. Yet by putting cash at the heart of an investment process, investors can gain the conviction to overcome short-term pressures and create a portfolio with differentiated positions and low correlations to other comparable equity strategies in complex and changing market conditions.
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. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. CFROI is a trademark or registered trademark of Credit Suisse Group AG or its affiliates in the US and other countries.
David Dalgas is Chief Investment Officer—Global Core Equity at AllianceBernstein.