24 February 2019
Rather than chasing the dolphin — or the headlines — investors would do well to follow the cash flow while remaining cautious overall. Photo: Reuters
Rather than chasing the dolphin — or the headlines — investors would do well to follow the cash flow while remaining cautious overall. Photo: Reuters

Swimming with the dolphins

Markets lately have resembled a dolphin at sea, leaping and diving in spectacular fashion. Observers often don’t know where to look for the dolphin next. That has been the case in recent weeks, with the markets sometimes leaping up at night before crashing down the next morning.

So how should you play these non-directional markets? In my opinion, you shouldn’t. Leave that to short-term traders and computer algorithms. But if your intent as an investor is to seek solid returns over the long term in order to pay future college expenses or fund a comfortable retirement, you need to ask yourself the following questions:

1. Do headlines from Washington or Wall Street really matter? The answer, after years of sifting through empirical data is ‘no’. Headlines matter to voters, but rarely to investors. And in my view, they aren’t correlated with returns.

2. Then what is correlated with long-term returns? In my experience it’s free cash flow generation and free cash flow yield.

3. What drives free cash flow? To my way of thinking, free cash flow is driven by economic growth, margins, proper stewardship of capital and sound management.

4. What other valuation metrics bear watching? The price-to-free cash flow ratio matters a lot, but in my view, so do the price-to-book ratio and the cyclically adjusted price-to-earnings ratio (CAPE), which are both quite rich too.

Some perspective

Today’s headlines are awash with talk of trade wars and tariffs. Yes, tariffs matter, but only to certain companies and industries and to farmers of particular crops. From an economic standpoint, they don’t impact the market as a whole and aren’t of such a magnitude that they’ll end the economic cycle. The recently passed US tax cuts alone dwarf all the tariffs being discussed, making the latest trade-related moves out of Washington look small by comparison.

As far as free cash flow generation is concerned, it’s off its record high per dollar put into the market, but is it going higher? Maybe. But my work shows me that future free cash flow generation is under pressure from rising labor outlays, higher borrowing costs and increasing general and administrative expenses. Free cash flow yield looks less promising at this point than it did during the spectacular rise we witnessed earlier in this long business cycle.

While the economy continues to grow and assets are still being used productively, there are signs that global economic growth may have begun to slow. In my view, economic growth is necessary, but not sufficient, for improved profits and cash flow. In order to continue to grow, cash flow companies need a decline in the cost of capital, steady-to-falling wages or a sizable rise in productivity.

So despite the recent market pullback, the price of entry into the market is still historically high, in my opinion. Consequently, in balancing risk and reward, it doesn’t make sense to be fully invested until risk asset price levels recede further.

So rather than chasing the dolphin — or the headlines — follow the cash flow while remaining cautious. If you are looking for a place to ride out these choppy market waters while awaiting more compelling equity valuations, the short end of the US investment-grade corporate bond market looks to be a less risky part of the market.

Short-term high grade corporates have become relatively more attractive lately due to a number of technical factors, chief among them a one-time shift out of short-maturity corporate bonds as companies bring home cash held outside of the United States as a result of the recent tax act.

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The author is Chief Investment Strategist at Massachusetts Financial Services

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