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Recently in this space, the concept of quality investing and its varying forms and fashion is being highlighted and one of the points being made is that this style doesn't have a static definition.
However, it does have hallmarks and one of those prodigious generation of free cash flow. Although some junky stocks sparked the cyclical value rally earlier this year, a lesson from the 2020 coronavirus market swoon advisors ought to remind investors of is free cash flow never goes out of style and it is a primary indicator of quality.
The TrimTabs U.S. Free Cash Flow Quality ETF (CBOE:TTAC) is a prime example of an exchange traded fund that puts the validity of an emphasis on free cash flow into real time practice. TTAC, which has nearly $204 million in assets under management and soon turns five years old, proves making the cash call can be worth it for clients. The fund is beating the S&P 500 by nearly 200 basis points year-to-date.
Actively managed, TTAC holds 143 stocks, as of the end of the second quarter, and looks to beat the widely followed Russel 3000 Index.
'Most Important Metric'
As advisors well know, investing requires some working knowledge of a wide array of metrics. Some market experts argue free cash flow is the most important. For clients seeking long-term durability with less turbulence, free cash flow is critical.
“One of the most important traits you should seek in a potential investment is the firm's ability to generate cash,” according to Morningstar. “Many companies have shown profits on the income statement but stumbled later because of insufficient cash flows. A good look at the statement of cash flows for those companies may have warned investors that rocky times were ahead.”
To that end, it's not surprising that some of the largest companies in the U.S., plenty of which line the TTAC roster, attained that status due in part to cash flow-generating proficiency. Think TTAC holdings Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Alphabet (NASDAQ:GOOG), just to name a few.
Extending the themes of importance of free cash flow and the relevancy of TTAC in today's investing environment, not only is it the capital companies have left over after all expenditures are accounted for, it can be used to fund buybacks and dividends by financially prudent companies, including some TTAC components, that don't want to borrow to finance returns of capital to shareholders.
Plus, unlike earnings, there's no really no way companies can fiddle with free cash flow. They either have it or they don't.
“Knowing the company’s free cash flow enables management to decide on future ventures that would improve the shareholder value. Additionally, having an abundant FCF indicates that a company is capable of paying its monthly dues. Companies can also use their FCF to expand business operations or pursue other short-term investments,” according to the Corporate Finance Institute. “Compared to earnings per se, free cash flow is more transparent in showing the company’s potential to produce cash and profits.”
Talking TTAC
Investing for free cash flow requires flexibility. TTAC has it while some supposedly competing strategies have that flexibility in smaller doses or lack it entirely.
Specific to TTAC, being an active fund allows for overweighting tech – a prodigious generator of free cash – while minimizing allocations to capital-intensive, heavily indebted sectors with spotty cash flow histories. That's to clients' long-term benefits. Additionally, a new management team is proving sturdy.
“The new team took the reins in January 2021 and looking at their new performance record, they have posted admirable results,” notes Morningstar. “Since the manager change, ( this year), the fund returned 17.1% through month-end, topping its average peer's 13.7% and outperforming the Russell 1000 Growth Index’s 13.8% return.”
Past performance isn't a promise of future returns, but cash flow is always fashionable.
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