The resilience of high cash flow companies

Paul: [00:00:00] Welcome to Index Ideas from FTSE Russell. I'm Paul Amery, your podcast host. In the podcast we explore index ideas that can help address real world investment themes and challenges. The concepts that we discuss in the podcast are not investment advice. They represent transparent, systematic approaches that may be developed into indices and made available for broad public use. Any reference to potential strategies is intended for informational and educational purposes only.

In this episode, I'm joined by Emerald Yau, who is head of equity index product management for FTSE Russell in Asia. Emerald is here to talk about an important measure of equity market resilience--free cash flow--and how her team has recently designed a set of indices to embed this measure. Emerald, welcome to the podcast.

Emerald: [00:00:45] Thanks, Paul, for inviting me.

Paul: [00:00:46] So what is free cash flow?

Emerald: [00:00:48] It's a very simple concept. It is an indicator that helps investors to measure a company's financial health. Simply put, the formula of free cash flow is equal to the operating cash flow minus the capital expenditure. Essentially, free cash flow is representing the true cash that the company generates after accounting for the capital expenditures that it needs to maintain its operations. Very simple concept.

Paul: [00:01:16] So why are companies with high free cash flow generally considered to be financially more stable?

Emerald: [00:01:22] Well, free cash flow represents the money that a company can freely deploy. That means that the company can use the cash to pay dividends, they can use it to reduce debt, invest in R&D, pursue strategic acquisitions, etc, etc. That means the company is better equipped to brace for any market turbulence and to respond quickly to competitive pressures. So, in a sense, providing better financial stability.

Paul: [00:01:52] For investors who might be concerned about potential instability in the equity markets, one very popular strategy has always been to prioritise dividends. Why might an investor go for free cash flow as a defensive measure, rather than just choosing high dividend-paying stocks?

Emerald: [00:02:09] Yeah, so under volatile market conditions, I wouldn't say defensive investors must prioritise a free cash flow solution over the dividend solution. Both of these solutions typically will offer a higher dividend return versus the underlying universe. So during market volatile times, both are defensive in a sense.

But in terms of the free cash flow solution, I will use the example of Russell 1000 Cash Flow Focus Index, which contains 100 US large-cap companies with high free cash flow. So according to the back-test history, if we look at the major market volatility periods, during the global financial crisis in 2008-2009, the cash flow index outperformed the base universe by 6.7%. And during the Covid market crash in the early 2020s, the cash flow-focused index outperformed the base universe by 4%.

Now, both free cash flow and dividend solutions are defensive. However, I want to say one more thing about this: the beauty of the free cash flow solutions is that the companies with high free cash flow can thrive even when the market is on the up cycle.

For example, when the growth stocks are taking charge, that is what typically you see missing in the dividend solutions. So think about this, right? I mentioned before that companies with high free cash flow, they have the ability, the flexibility to invest in R&D, to do strategic acquisitions, etc. So this empowers the companies with high free cash flow to be more competitive and to have the ability to be more innovative. So in turn, that can support some potential revenue growth and, potentially, stock price appreciation.

Paul: [00:04:04] So this type of index is a more all-weather strategy than just a dividend focus?

Emerald: [00:04:09] I would say so: this is exactly how I would coin it. This is an all-weather solution. And in fact it is exactly what we have observed in our FTSE Cash Flow Focus indices: that they are keeping up with the market beta in the market upcycle.

Paul: [00:04:24] Okay. Thank you. Emerald. You mentioned a couple of minutes ago that one example of this index series is the Russell Free Cash Flow index. And you said that you started from the 1000 stocks in the Russell 1000 index, which is FTSE Russell's main US large-cap index. And then you arrive eventually at 100 stocks with the highest free cash flow. Are there some exclusions or filters that you apply before you arrive at the final 100?

Emerald: [00:04:49] We do remove banks, insurance companies and REITs from this index series. The reason is because these companies’ business models, accounting practices and income payout structures differ significantly and fundamentally from the non-financial and non-REITs companies, making it not suitable to apply the same free cash flow measure to analyse the financials’ performance. So, looking at these companies from a free cash flow point of view, we justify the removal of these companies under the methodology. But we also filter further to focus on the companies with positive free cash flow, higher quality and lower volatility.

Paul: [00:05:36] Right. So we remove the financials stocks first. And then we go through these other construction steps. And at the end we arrive with 100 stocks. How do we then weight those stocks in the free cash flow index?

Emerald: [00:05:46] So we rank the securities on the free cash flow measure. And then we look at what are the rankings. And in fact, in the index series some indices will also have additional ranking measures looking at book-to-price, dividends, earnings, in addition to the free cash flow measure in the ranking process. It’s an index-dependent approach. But the top-ranked companies are selected, typically 50 to 100 stocks, and they are weighted by the investable market cap.

Paul: [00:06:16] Okay, great. And when do we rebalance the index and how often does that take place?

Emerald: [00:06:21] The rebalancing is quarterly, in March. June, September, and December.

Paul: [00:06:26] And what kind of industry exposures does this type of approach typically lead to in the index?

Emerald: [00:06:32] So, as I mentioned before, banks insurance companies and REITs are excluded. So you will essentially will see a low or no exposure in financials and the real estate industry. But in terms of other industries the indices tend to be quite well-balanced, well-diversified. But how exactly is this distribution? It depends on the base universe. So, for example, the Russell 1000 Cash Flow Focus index has a relatively high technology exposure, at around 30%, whereas the FTSE Asia Pacific ex-Japan Cash Flow focussed index will have an overweight in the energy industry versus its base universe.

Paul: [00:07:14] And are there any typical factor exposures that come from this type of approach?

Emerald: [00:07:19] Yes we do. Just because we do filter out the lower-quality and higher-volatility type of companies. So, what we’re left with on the factor side: you will see the higher quality measure as well as some lower volatility.

Paul: [00:07:33] And you mentioned risk-return outcomes earlier. Obviously in these back-tests, past performance is not any guarantee of what might happen next. But is there anything else you wanted to add on that particular topic?

Emerald: [00:07:44] As I mentioned before, this is a very interesting approach that can add protection during market volatility, but it's also keeping up with the market base during the up cycle. So, all-in-all, on a longer-term basis, the return--typically what we have seen in the back-test history--has been outperforming the base universe. And in a sense, this is also a lower-volatility approach and on a risk-return basis it has been showing a better risk-return profile versus the base universe.

Paul: [00:08:17] What kind of demand have you been seeing from FTSE Russell clients for this type of strategy index?

Emerald: [00:08:23] So we have launched an ETF as well as an index fund in mainland China. That's based on a cash flow focus index as well. Outside of mainland China, we have very active conversations with our clients globally on the cash flow indices. So we have seven indices that are live right now, covering the China A-Shares market, the Southbound Stock Connect, Asia Pacific ex-Japan, Japan, Developed Europe, the US large cap and the US small cap markets. But with the conversations with clients, we are also looking at the UK universe, the overall China universe, the global universe, etc. So, I would say this methodology is quite applicable to different regions and even to individual countries. So we are working with clients to see what they are interested in from a starting universe point of view and run the simulation.

Paul: [00:09:21] Thank you Emerald. And finally, where can anyone listening who's interested in this strategy go to find out more about how it works, the methodology, and so on?

Emerald: [00:09:29] Well, definitely: you can find the information on the FTSE Russell website. So we have a landing page. You can just search for the FTSE Cash Flow Focus index series. So we have a landing page, we have a blog available, as well as all the factsheets for the seven available indices also online.

Paul: [00:09:47] Thank you very much, Emerald, and thank you for joining me for this podcast.

Emerald: [00:09:51] Thank you, Paul.

Paul: [00:09:51] And that's it for this episode. If you've enjoyed this conversation, then please do follow us and give us a positive rating or review on your podcast app of choice. And if you'd like to get in touch with the show, you can do that via the email fmt@lseg.com. But for now, from me, Paul Amery, goodbye.