Investors and advisors face a plethora of headwinds in 2022. From a hawkish Federal Reserve policy pivot to inflation concerns, investors could expect the market environment to change dramatically this year.
In a rising-rate environment, the value world has historically outperformed its growth counterpart. Many market participants have enjoyed the recent run-up of high-flying growth names, especially in the technology industry. Going forward, however, investors should ask themselves: “Do these companies have the balance sheets to survive and thrive in a rising-rate environment?”
Making The Switch: Growth To Value
Investors can answer that question by looking at the U.S. market over the last six months. In general, we’ve begun to see a changing of the guard as value stocks have started to outperform growth, signaling a sentiment shift toward companies with strong cash flows. This is due, in part, to the resilience of attractively valued companies in periods of higher inflation and rising interest rates.
The potential for more volatility is clear this year. Now may be the time to make the switch from growth to value. But, what makes a certain value strategy more attractive than another?
Free Cash Flow Focus
There are countless ways to invest in value stocks. Whether it is your traditional price-to-book strategy or a more complicated quantitative approach, multiple methods can yield multiple results. In the current environment, however, I believe cash and free cash flow represent one metric that’s worth a closer look. In order to understand the true value of a company, and find potentially attractive investment opportunities in 2022, investors need to understand both tangible and intangible assets. This can be done by determining a company’s free cash flow.
Companies with high free cash flow have traditionally outperformed other value stocks in a rising-rate environment. Understanding a company's free cash flow is one of the most important financial metrics to consider when investing in value names — especially for buy-and-hold investors.
Free cash flow can be calculated by subtracting a company’s capital expenditures from its cash flow. These expenditures include taxes, expenses, interest and long-term investments. Once calculated, that figure offers investors a holistic measure of the remaining cash, excluding many assumptions and referring to the cash in hand left over after paying the bills.
Understanding how to determine a company’s cash flow can allow an investor to equate the value of a company to its ability to withstand external market pressures. This analytical approach will be critical as market participants are likely to be influenced by emotions and headlines, such as when uncertainty arises.
Benefits of High Free Cash Flow
With multiple headwinds facing the economy this year, much of the market agrees that the growth sector will be challenged, broadly speaking. In a worst-case scenario, we could be in for a long slog of weak returns in the growth sector. This brings us back to our value discussion, especially companies with high free cash flow.
Companies with high free cash flow are able to pay dividends, buy back stock, make acquisitions, expand businesses and pay debts. Such companies have an advantage when rates are rising, due to strong balance sheets and cash reserves enabling them to grow even in a more “expensive” environment.