This story was originally published on by Mark Melin. For additional behind the scenes insight, see commentary provided at the end of this article.


There is one value factor that currently looks inexpensive but actually has performed well over time even when it is expensive. That factor, free cash flow, often used for corporate expansion or to pay investors dividends, should be a core or default component of a value investing portfolio, research a May 24 report from Bernstein’s Global Quantitative Strategy team opines.

Cash Flow Metrics Free Cash Flow

Free cash flow value factor has reasonable returns without the volatility

In quantitative strategy, correlations between markets and even indicators are sometimes used in the analysis as a key insight benchmark into the validity of a market trend or used as part of the investment thesis. What is unusual about free cash flow when used as in indicator “when macro visibility is low or stock correlations are high,” Alla Harmsworth and the research team at Bernstein observed. In the report “Free Cash Flow and walking the Value-Quality tightrope,” this value factor is shown to have an “impressive risk-return profile in every region” but “without the volatility.”

Free cash flow is a strategy that works in a variety of situations including “when macro visibility is low or stock correlations are high,” Alla Harmsworth and the research team at Bernstein observed. In the report “Free Cash Flow and walking the Value-Quality tightrope,” the value factor linked to important fundamental monetary flexibility has an “impressive risk-return profile in every region” but “without the volatility,” typically a defensive point of view, which the report touts as a benefit.

What’s more, “free cash flow yield gives an enviably smooth performance risk-adjusted through the cycle that beats all other key styles.”  The report points out minor superhuman status, saying that “remarkably” even when the factor’s valuations are high, normally a point of exhaustion of other looks at valuation such as the price earnings ratio, performance has been positive. Harmsworth says this is “another reflection of its ability to generate a relatively defensive return stream and work through most environments.”.

In algorithmic analysis, indicators typically have a cross-pollination impact where there is a sensitivity from one factor to the other. With free cash flow, Bernstein observes, the factor has “less sensitivity” than others.

Here Harmsworth is signing a song professional investors often want to hear most: factor durability, consistent returns streams through a variety of market cycles with muted volatility.

A value factor for current times: Free cash flow works during policy uncertainty and volatility

Relative to today’s market environment, when “policy uncertainty” appears, a phrase that currently might keep fundamental investors up at night, free cash flow is particularly interesting in such market environments.

Harmsworth notes that as policy uncertainty continues to climb of late, volatility is likely to rear is head in the coming months and quarters, and investors should begin to plan for such probabilities. In fact, free cash flow can be used as a “shield against policy uncertaninty and rising volatility.” To a noncorrelated investment practitioner, this might seem odd. During stock market crisis most securities tied to the economy have a history of correlating to one, typically finding difficulty during volatile markets. But Bernstein touts this as a benefit, pointing to other noncorrelated factors.

Going back to 1991, Bernstein ran an analysis of returns across geographic regions looking for correlation trends. The factor worked in all regions, with Asia ex Japan delivering the best absolute results, with 9.08% returns but a 12.27% standard deviation. Emerging markets were also positive, but the lowest volatility point was found in Europe, where a 7.83% standard deviation was linked to a 6.16% annualized return.

While the Bernstein report almost exclusively looked at the factor from a quantitative standpoint, there is an economic rationale for its success as well. Free cash flow is often used to achieve goals investors like: expansion, dividends, or debt reduction. It is a sign of a healthy company. Firms that are overburdened with debt payments typically do not have a significant free cash flow. Thus, from many standpoints, free cash flow is an indicator that, over the long term, can be negatively correlated with leverage, particularly during high interest rate environments when the cost of carry would consume available cash.

Top free cash flow stocks in Europe included consumer discretionary names such as Intercontinental Hotels, Valeo, WPP, and Christian Dior. In the US similar names included some names from the generally shunned retail sector such as Nordstrom, Target, Macys, Best Buy, Kohl’s and Bed Bath & Beyond.


Insight / Analysis / Opinion:

This research was interesting, but it didn’t look at free cash flow as a value factor during crisis, a time when most stocks correlate to one, so I’m not sure the claim this strategy works during volatility is entirely accurate


Tags: Bernstein quantitative analysis Free cash flow (FCF) analysis Investing in uncertainty and volatility Value factor investing