Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
Sunny summer days bring back memories of heading to the amusement park at the crack of dawn and riding roller coasters into the evening, with breaks for carnival food along the way.
Investors can experience similar thrills in the markets, which often act like roller coasters with wild ups and downs. The U.S. Free Cash portfolio is a case in point because it provided surging highs and shocking lows over the years, which makes it well worth revisiting.
The original 10-stock version of the portfolio rode its way up to average annual gains of 20.3 per cent over the 25 years through to the end of this past June. By comparison, the S&P 500 index climbed by an average of 7.7 per cent over the same period.
The portfolio loads up on cheap stocks with lots of free cash flow. More specifically, it buys each month an equal-dollar amount of the 10 stocks with the lowest enterprise-value to free-cash-flow ratios from the large stocks in the S&P 500 index.
(All of the returns herein are based on monthly data from Bloomberg, and the returns include dividend reinvestment but not fund fees, taxes, commissions or other trading costs. The portfolios are rebalanced monthly, and the results are presented in U.S. dollar terms.)
Enterprise value, put simply, is equal to a firm’s market capitalization plus its net debt. Free cash flow is the amount of money a company can distribute to its shareholders while maintaining its operations. In this case, it is approximated by subtracting capital expenditures from cash flow generated by operations.
The accompanying graph shows the returns generated by the market index, the U.S. Free Cash portfolio and two additional variants of the portfolio that follow the same approach but hold 20 and 30 stocks.
The returns of all three versions of the U.S. Free Cash portfolio have been superb. The 20- and 30-stock variants had average annual returns of 16.7 per cent and 16.4 per cent over the 25 years to the end of this past June.
But those superlative average returns came with some very steep up- and downswings. The second graph highlights down periods for the 10-stock portfolio and market index. (The 20- and 30-stock portfolios were omitted to avoid cluttering the graph, but behaved similarly to the 10-stock portfolio in downturns.)
The financial crisis of 2008-2009 was the worst crash for both the market index and U.S. Free Cash portfolios over the period. The market index declined 51 per cent from its former high to its low in 2009. The portfolios fared worse, with plunges of 60, 66 and 62 per cent for the 10-, 20- and 30-stock portfolios.
The second worst showing for the market was its tumble after the internet bubble burst in 2000, which led to a decline of 45 per cent. The U.S. Free Cash portfolios fared better with declines of 40, 32 and 32 per cent for the 10-, 20- and 30-stock portfolios. Mind you, the portfolios had climbed nicely before falling and recovered quickly.
The portfolios didn’t fare as well as the overall market in the sudden crash of early 2020 prompted by the onset of COVID-19 restrictions, when the S&P 500 gave up 20 per cent. At the same time, the portfolios plunged 40, 39 and 33 per cent for the 10-, 20- and 30-stock versions. They also took longer than the market to fully recover.
One thing to note here is that, while the more diversified 20- and 30- stock versions did prove less volatile than the 10-stock portfolio, they didn’t offer as much downside protection as I expected.
Over all, the 10-, 20- and 30-stock portfolios were about 89, 64 and 53 per cent more volatile than the market index over the 25-year period.
While the U.S. Free Cash portfolio generated outsized returns, it has also been highly volatile. Investors should beware before jumping on this particularly wild roller-coaster ride.
You can find the stocks in the U.S. Free Cash portfolio via this link, which also provides updates to many of the other portfolios I track for The Globe and Mail.
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