Four out of every five companies in the S&P 500 managed to top profit forecasts in last year’s third quarter. Trouble is, those “earnings beats” can be a work of fiction. Today’s chief financial officers are encouraged to tell analysts what to expect, and then have many levers at their disposal to arrive at a number for quarterly net income that keeps investors happy.
The risk to fudging the numbers is obvious. Early warning signs of deteriorating business conditions can be masked when companies reallocate certain expenses—and thus temporarily pump up stated profits.
For this reason, Janet Johnston, a portfolio manager at TrimTabs Asset Management, says investors might want to turn their focus away from operating earnings and toward another key metric that can “bring sunlight to disinfect this issue,” and provide a way to outperform the market: free cash flow.
It’s “the last unmined source of alpha,” she says.
As Johnston and other proponents of free cash flow suggest, it’s wise to measure corporate health by focusing on how much money is actually landing in a firm’s bank account each quarter. Not only is this reported in a much more accurate fashion than operating income, it gauges the true wealth created by a business. “Cash is cash, and not subject to interpretation,” says Johnston.
A simple example shows why free cash flow is a far better gauge than operating cash flow. Suppose you have two companies operating in the same industry, each with the same levels of sales and operating income. The first company also carries $100 million in debt while the second is debt-free. By accounting for interest paid on debt (and other “below the line” cash flow figures), the debt-free firm emerges as far more prosperous. Moreover, if industry conditions worsen, the debt-free company will have a much greater ability to weather the downturn.
A small yet growing roster of ETFs have emerged to focus squarely on free cash flow. They each take a distinct approach and have delivered varying performance results.
Multiple Choice
As companies generate robust amounts of free cash flow, they can pursue multiple shareholder-friendly moves. They can boost their dividends, pay down debt, invest in new plants and equipment, make acquisitions or buy back their own stock.
For Johnston and her colleagues at TrimTabs, a look at buybacks and debt—and how they inter-relate—are paramount. Buybacks aren’t delivering the bang-for-the-buck you may suspect. The Invesco BuyBack Achievers ETF (PKW), for example, has trailed the S&P 500 by roughly three percentage points per year over the past five years, according to Morningstar. With more than $1 billion in assets, this fund is the largest of the group focused on buybacks.