Why free cash flow is everything when stocks are falling
Managing Director, Chief Investment Officer, and Portfolio Manager
With the Standard & Poor’s 500 Index in bear territory, some investors are no doubt wondering how they can protect themselves from future equity declines. While it might be impossible to dodge a bear market entirely, at Jensen we believe it’s important to focus on quality companies to help reduce portfolio risk.
Why? Because we believe these companies can weather the brewing storm better than others. In our experience, quality companies are better positioned to avoid taking on excessive debt, increase their research and development efforts, and maybe even acquire a competitor or two.
What do quality companies have going for them that makes this possible? It’s simple: free cash flow.
Cash is king
We always say that cash is king because it gives companies so much flexibility. But it’s times like this that prove the point most forcefully. Free cash flow is the cash a company has in excess of operating expenses and fixed costs.
With inflation running at historic highs and the Federal Reserve instituting one interest rate hike after another, many companies are feeling the pinch. And that’s the point. The Fed wants to rein in borrowing and spending.
For companies that don’t have a lot of cash on hand, it should work. These businesses might need to take a step back from their marketing efforts, reduce headcount, or cut down on reinvestment. Some companies might be so restrained that they will be unable to sustain the same level of operations as before. Others might be forced to shutter. It’s not unusual to see a rise in bankruptcies during economic slowdowns.
But companies with ample cash on their balance sheets are in a better position to withstand negative economic forces. They can plow money back into their businesses or make acquisitions of cash-strapped competitors. In the short term, they can continue to reward shareholders with dividends and buybacks. As a result, these companies are poised to emerge from downturns in even stronger positions, ready for a new phase of growth.
A focus on quality
At Jensen, free cash flow is one of the key areas we look at when analyzing companies we want to include in our portfolios. Though free cash flow is somewhat different than our quality screen, the two are related.
We start our investment process by screening for companies that have returns on equity (ROE) in excess of 15% for each of the past 10 years. By applying this stringent requirement, we can eliminate most stocks and are left with just a few hundred potential names to research further. This screen is only a starting point for further analysis.
From here we focus on both qualitative and quantitative factors. In our experience, high-ROE businesses typically generate strong free cash flow (though there are exceptions). These attributes are compelling for long-term investors.
Take, for example, Apple (AAPL), a company that entered the Jensen Quality Growth Strategy’s Model Portfolio (“Quality Growth Portfolio”) in 2016. Though Apple stock had performed exceedingly well for more than a decade before that, we did not include it in our portfolio because it hadn’t yet met our 10-year ROE requirement. Today, it does.
In the last 12 months, Apple reached a historic milestone: $100 billion in free cash flow, thanks in large measure to the continuing strong sales of the iPhone—despite the economic slowdown in some of its biggest markets. This amount of cash generation gives Apple tremendous flexibility during what could be a difficult economic period.
Know what you own
Along with putting companies in an enviable financial position, our experience has shown that free cash flow also gives us a level of comfort knowing that our portfolio companies have some predictability in volatile market environments. The cash cushion provides them with the means to ride out the tough economic cycles and maintain the level of performance they are known for.
As concentrated, high-conviction investors, we see great value in this predictability. Knowing what we own is a key component of achieving our goal of building portfolios with less risk than the overall market.
What’s more, free cash flow is difficult to manipulate, unlike other metrics such as earnings. It’s an accurate representation of a company’s financial health, similar to a personal checking account. In other words, it’s hard to fake cash.
One company that exemplifies this is Pfizer (PFE), the drug giant, one of the holdings in the Quality Growth Portfolio. Thanks to its blockbuster COVID-19 vaccine, Pfizer generated $29 billion in free cash flow for the calendar year of 2021. That allows Pfizer to make strategic acquisitions to find its next blockbuster or fill gaps in its current pipeline. We believe that cash will put Pfizer on a path to consistent profitability coming out of the pandemic even once vaccine sales cool.
An antidote to higher interest rates
In addition to helping companies deal with a slowdown, cash also helps companies fund their own expansion plans. As interest rates rise, so too do borrowing costs. Companies will feel the pinch as more of their profits go toward servicing their debt.
But businesses with significant free cash flow don’t need to go to the debt markets if it’s not advantageous.
Microsoft (MSFT) is one such company in our Quality Growth Portfolio. The company has $65 billion in free cash flow, as of the end of the second quarter 2022, much of it due to growing demand for its cloud computing services. At the same time, Microsoft has $47 billion in debt, which we believe given its cash position is a reasonable level. We are confident that Microsoft will continue to pay dividends and repurchase shares, because it has the cash to do so.
Never underestimate the power of cash
As investors brace for an economic slowdown, there’s comfort in knowing what you own. Companies with strong free cash flow give us a measure of reassurance that their financial health won’t be derailed if they hit a rough patch. Our experience has shown that they will continue to reinvest in their business, pay down debt, make acquisitions—and reward shareholders.
For a complete copy of current holdings in the Jensen Quality Growth Model Portfolio, please email [email protected].
The Jensen Quality Growth Strategy Model Portfolio is a representative account of the Jensen Quality Growth Strategy. The companies discussed in this article are solely intended to illustrate the application of our investment approach and are not to be considered a recommendation by Jensen. Our views expressed herein are subject to change and should not be construed as a recommendation or offer to buy or sell any security and are not designed or intended as a basis or determination for making any investment decision for any security. Our discussions should not be construed as an indication that an investment in a security has been or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of any security discussed herein.
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