Companies that continue to grow free cash flow over time suggest that they’re operating effectively and focused on sustainable success. Despite market pressures, a company generating high free cash flow could be better positioned for future long-term growth while being able to withstand short-term risks like policy changes and inflation.
On the other hand, companies that lack high free cash flow and trade at high price-to-earnings valuations may continue to be more sensitive to rising rates and market shifts. These are typically, but not universally, growth companies in the technology industry that have led the long bull market. Such growth names have done particularly well during the pandemic due to a low-interest-rate environment.
The Federal Reserve is signaling that more rate increases could be on the horizon, which does not bode well for growth companies with weak cash flow. Companies with high free cash flow will become more attractive as they boast strong fundamentals and the ability to thrive even in a rising-rate environment.
Free Cash Flow Is King
As U.S. markets come out of the Covid-19 pandemic, following countrywide shutdowns and an influx of government stimulus, participants can expect inflation fears to become reality. In 2022, investors need to protect their portfolios against headwinds that some might not have experienced before. In an environment where price-to-earnings are likely to contract, companies with high free cash flow and lower price-to-earnings might be better going forward.
Sean O’Hara is the president of Pacer ETFs Distributors ($10.2 billion in AUM as of Dec. 31, 2021), a Malvern, Pennsylvania-based ETF issuer with over 43 thematic and rules-based ETF strategies.