Cash Flow is King

Published On: August 5, 2024

Written by: Ben Atwater and Matt Malick

One of the hardest parts of investing is sticking to a process. For us, this often occurs when speculative investment themes cause markets to skyrocket higher. Investors, in turn, can feel pressure to change course and chase speculative returns.

But when investors feel they are missing upside, it is usually a sign that risk appetites are too high. Conversely, when it starts to feel like the bottom is falling out, it usually means the market is oversold. Caving to pressure to change course, whether the market is heading higher or lower, is not a sound strategy.

We base our equity process on free cash flow, a profitability measure that ignores non-cash accounting items and is difficult for companies to manipulate. If a company consistently generates healthy free cash flow, then its stock price should have a margin of safety, theoretically limiting losses when the next correction or bear market inevitably arrives.

But throughout 2023 and the first half of 2024, stock markets skyrocketed higher and a small handful of technology stocks, specifically those with perceived potential in artificial intelligence, accounted for most of the market’s outsized gains.

To be sure, we own some of these names, including Apple, Alphabet, Accenture and Microsoft. But these stocks are part of a diversified portfolio of companies in various sectors, all of which have a history of solid free cash flow. As a result, while we had solid absolute returns, a market led by a speculative A.I. frenzy carried the day.

Amidst a surge in volatility over the past week, we have seen the benefits of sticking to our cash flow-based equity approach. Losses are inevitable when markets drop quickly. But strong company fundamentals can limit equity losses for investors.

Equities are never truly “safe” in the short run. Prices are subject to the manic behavior of the market. Wild swings will happen from day to day. But given time, stock prices should track underlying companies’ profitability, making free cash flow of paramount importance.

Prudence, patience and process will, in the end, serve our clients well.