The case for free cash flow value opportunities

In an environment potentially moving towards slowdown and recession, Nick Davies of Polar Capital explains why dividends and free cash flow yields are increasingly compelling alternatives to growth.

For many, value investing over the past decade has been fraught with difficulty and low valuation multiples have consistently failed to signal mean reversion opportunities. Quant screens that sift out stocks with low P/Es or low price-to-book multiples have tended to produce stocks liable to technological disruption and the effects of financial repression.

Conversely, scarce-growth stocks re-rated this year to higher, more extreme multiples (as illustrated below). Any value outperformance has been short and sweet, so benefitting from it requires good market timing, making value investing less successful as a buy and hold strategy.

Style divergences have shown signs of reversing in recent weeks

Source: Datastream; Kepler Cheuvreux; October 2019.

However, there is an alternative to increasingly expensive growth stocks: investors should consider focussing on free cash flow yields as a value factor, filtering out the most blatantly disrupted sectors. This period of growth outperformance has been a long one, with many investors losing their valuation discipline and hiding behind low bond yields.

We would encourage investors to use free cash flow yield as a valuation metric, as we feel it is attractive for a number of reasons. Firstly, good free cash flow coverage of dividends gives increased confidence that the current payment level is sustainable; secondly, it increases the resilience and flexibility of a company to shocks, either allowing it to pay down debt or respond to any capex opportunities. If management are doing sensible things with their marginal use of capital, then strong free cash flow is both an indicator of current cheapness and a driver of future growth at good returns on capital.

Data from Bernstein Research indicates that free cash flow factors are cheap everywhere, particularly in Europe, with one exception being Japan. They historically perform strongest in slowing and recessionary phases and weakest during expansionary phases. Since the cycle will transition to a slowdown eventually, whether it be sooner or later, free cash flow factors are well positioned from both a valuation and cycle-timing standpoint.

For investors, Europe’s large-cap, defensive dividend payers are an outstanding opportunity across asset classes. Europe is also an excellent region for income investors because it has relatively low-trend growth and possesses an abundance of mature, cash-generative businesses. Late in the cycle, resilient businesses, that deliver steady earnings growth over the medium term, in most macro environments, at attractive valuations, are the ones that should be most attractive to investors.

Even within our own investment philosophy, we focus on the fact that a successful medium-term investment outcome is driven by both an attractive starting valuation and an ability to deliver some compound cash-flow growth over the medium term. We highly advocate buying good companies when they are out of favour. Investment style is not a binary choice between value or growth, but instead there is a spectrum which is where, and why, metrics such as free cash flow yield can be incredibly useful. In an environment potentially moving towards slowdown and recession, dividends and free cash flow yields are increasingly compelling alternatives to growth.


Issued by Polar Capital

Disclaimer

This document does not constitute an offer or solicitation of an offer to make an investment into any fund managed by Polar Capital. Polar Capital LLP is a limited liability partnership number OC314700. It is authorised and regulated by UK Financial Conduct Authority and registered as an investment adviser with the US Securities & Exchange Commission. A list of members is open to inspection at the registered office, 16 Palace Street, London, SW1E 5JD.

The law restricts distribution of this document in certain jurisdictions; therefore, persons into whose possession this document comes should inform themselves about and observe any such restrictions. It is the responsibility of any person or persons in possession of this document to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not seek to make any recommendation to buy or sell any particular security or to adopt any specific investment strategy. All opinions and estimates in this report constitute the best judgment of Polar Capital as of the date hereof, but are subject to change without notice, and do not necessarily represent the views of Polar Capital. Past performance is not a guide to or indicative of future results.