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Free cash flow yield: a value factor for all seasons?

When people talk about value factors they are typically referring to either earnings yield or book yield (where book is equal to assets minus liabilities from the balance sheet). But there is actually a wide variety of other value factors, each with their own risk and return profile.

It is helpful to view value as a continuum, ranging from cyclical measures of value on one side to those value factors that also possess quality attributes on the other side. This concept is illustrated in Fig. 1. In this short note we will look at one particular “value-quality” factor, namely free cash flow (FCF) yield, which has some very attractive properties.

Figure 1: The value continuum

First, there is no standard definition of FCF yield. The definition we have chosen to use is:

FCF yield = (Cash flow from operations – CAPEX – dividends)/Market capitalisation

Note here that dividends are thought of as “fixed” in the sense that investors take a dim view of any company that cuts its dividends.

As quantitative investors, we take pride in being rules-based and systematic. This then means we can backtest our factors. We do this is in the following straightforward way:

1. Specify an investment universe
2. Calculate the FCF yield for each stock in the universe
3. Rank all stocks by FCF yield and then split into quintiles
4. Go long the top quintile funded by shorting the bottom quintile (i.e. we are equity market neutral)
5. The performance of this long/short portfolio is then calculated over the subsequent month
6. Steps 2 to 5 are then repeated at every month end during the backtest period (which here is from December 1990 to May 2017)
7. Calculate the cumulative performance over the entire backtest period

The results of this backtest for Europe, Japan and the US are plotted in Fig. 2. The cumulative performance lines all generally trend up throughout the market cycles. We can summarise a backtest performance by calculating an information ratio (IR), which is a measure of risk-adjusted return. An IR is defined as the average monthly performance divided by the standard deviation of the monthly returns, annualised. The rule of thumb is that an IR of 0.5 is “interesting” while an IR of 1 is “good.” In this backtest the regions have IRs ranging from 0.5 to 0.9.

 

Figure 2: Performance of free cash flow yield by region

Past performance is not a guide to future results

It turns out we can improve the results further by combining all three regions into a single global universe and rerunning the backtest. As shown in Fig. 3 we then increase the IR to over 1. As an aside, we often notice that quant factors backtest better, the greater the breadth of the opportunity set. This is partly due to the enhanced opportunities for diversification.

In Fig. 3 we also plot the performance of book yield, a deep, cyclical value factor. Sure, book yield outperforms over the long term but it also experiences significant drawdowns, as for example during the global financial crisis of 2007 to 2009. As a consequence book yield only generates a modest IR of 0.3.

Figure 3: Performance of free cash flow yield and book yield on a global universe

Past performance is not a guide to future results

Is there any economic rationale behind these widely differing results? Well, yes there is. High book yield stocks are usually financially distressed which means they tend to outperform when investors become risk seeking and underperform when risk aversion increases.

In contrast, high FCF yield stocks often have stable revenues, earnings and dividends and hence perform relatively well during bear markets. Furthermore the FCF yield still has price in the denominator which means the factor is biased towards cheaper stocks which tend to do well when economic fundamentals are improving.

Of course, no single factor outperforms all the time in all market conditions but as the charts illustrate, FCF yield has generated strong risk-adjusted returns over the last 25 years in many global regions. In addition, the factor has a convincing investment rationale which is a quant’s insurance policy against data mining.

It follows that FCF yield is one of many factors implemented in our Enhanced Index and Smarter Beta products.

 

Simon Whiteley

Senior Quantitative Strategist