Given current market volatility, we think now is a good time to revisit important value metrics with American Electric Power employees and retirees in our four-part series. In the second part of this four-part value series, we will look at the Price-to-Cash Flow ratio. Investors are often looking for ways to beat the market. If you're one of those investors, you should consider the following proven strategy that has been implemented by some great investors. Value investors figured out how to beat the average annualized returns of the S&P 500 a long time ago, and many have successful track records spanning several decades to prove it. The most famous value investor, of course, is Warren Buffett, but there are many others, including Benjamin Graham, David Dodd, Charlie Munger, Christopher Browne, and Seth Klarman.

This investment style focuses on four metrics that characterize a value investment. These four metrics include the Price-to-Earnings Ratio, the Price-to-Cash Flow Ratio, High Dividend Yield, and the Price-to-Book Ratio. These metrics, as you will see, are strong indicators of undervalued security. These undervalued American Electric Power securities consistently outperform the market. We will examine the effect of investing based on certain characteristics and how their investment returns are correlated. Today, we will look at the Price-to-Cash Flow ratio (P/CF), which we think can be a valuable tool in planning for American Electric Power employees' retirements. 

Many believe that using cash flow, rather than accounting earnings, delivers a more accurate picture of a company’s business performance, which in turn may lead to better investment decisions and investment performance. We understand the importance of researched solutions for American Electric Power employees. Set out below are the results of two Fama and French[1] backtests of the cash flow yield (the inverse of the P/CF ratio) data from 1951 to 2013. As of December 2013, there were 2,526 firms in the sample (Carlisle-PCF, P2). The value decile contained the 269 stocks with the highest cash flow yield, and the glamour decile contained the 311 stocks with the lowest cash flow yield. The average size of the glamour stocks is $4.74 billion and the value of stocks is $4.80 billion. (Note that the average is heavily skewed by the biggest companies.

For context, the smallest company included has a market capitalization today of $272 million, which is much smaller than the average, but still investable for most investors). Stocks with negative cash flow were excluded. Portfolios are formed on June 30 and rebalanced annually. In this backtest, the two portfolios are weighted by market capitalization, which means that bigger firms contribute more to the performance of the portfolio, and smaller firms contribute less. Here we can see that the value decile has comprehensively outperformed the glamour decile, returning 16.7 percent compound (18.6 percent in the average year) over the full period versus 9.3 percent for the glamour decile (11.5 percent in the average year) (Carlisle-PCF, P3).

The reason for the value’s outperformance is simply due to the fact that the value portfolios generated more cash flow per dollar invested; 27.2 percent versus 4.3 percent for the glamour portfolio (Carlisle-PCF, P5). (I used a rolling average.) The “average” I’ve quoted is for the full period. The rolling average has been higher, but it’s rarely been lower. The rolling average is the annualized average return over the 5 yrs following each year-long period (sometimes called a 5-year rolling return).

As we discussed previously, values' outperformance over glamour is not a historical anomaly. If we examine just the period since 1999, we find that, though the return is lower than the long-term average, value has continued to be the better bet. Value has continued to outperform glamour since 1999, beating it by 8.7 percent compounded, and 6.2 percent in the average year (Carlisle-PCF, P7).

The reason for lower returns recently may be due to the popularization of simple value strategies. However, I think it’s because the market is still working off the massive overvaluation of the late 1990s Dot Com boom. We think that a value-based strategy is the best course of action for American Electric Power employees and retirees.

Market capitalization-weighted returns are useful for demonstrating that the outperformance of value over glamour is not due to the value portfolios containing smaller stocks. Unless you’re running an index (or hugging an index), they’re not really meaningful. The easiest portfolio weighting strategy is to simply equally weight each position. (If we’re prepared to put up with a little extra volatility for a little extra return, we can also Kelly weight [2] our best ideas). Kelly Weighting is determined by the Kelly Criterion which is a formula used to determine what percentage of capital should be used in each trade to maximize long-term growth. There are two key components to the formula (Kelly % = W- [(1 - W) / R]): the winning probability factor (W) and the win/loss ratio (R). The winning probability is the probability trade will have a positive return.

The win/loss ratio is equal to the total positive trade amounts divided by the total negative trading amounts. The result of the formula will tell investors, what percentage of their total capital they should apply to each investment. The equal weight return statistics for the cash flow yield are displayed below. In the equal weight backtests, the value generated 20.7 percent compounded (23.8 percent on average), beating out glamour’s 9.3 percent compounded return (12.5 percent on average) (Carlisle-PCF, P9). You might note the small advantage for the cash flow yield’s value decile over the earnings yield’s value decile, 20.7 percent versus 20.1 percent. We’ll examine the significance of this small win by cash flow in the coming weeks.

In a Brandes Research Institute study, exhibit 6 on the following page illustrates the global all-cap findings across three price metrics. The results confirmed a consistent value premium across all metrics. We will focus on the P/CF ratio and the outperformance in the decile 10 value stocks. The smallest outperformance between decile 1 glamour stocks and decile 10 value stocks can be observed with the P/B measurement, where the average outperformance was 7.1% (Brandes, p. 8).

In the same Brandes study, they looked at how the Price-to-Cash Flow held up in the U.S., Non-U.S., and Emerging Markets. Looking at rolling 5-year annualized returns of Price-to-Cash Flow deciles from 1980-2014, it can be seen that the lower price-to-cash flow deciles significantly outperform those in the higher Price-to-Cash Flow deciles. The results can be seen on the graph “Appendix C: Findings by Regions Using P/CF Deciles”. While all of the lowest Price-to-Cash Flow deciles outperform the high Price-to-Cash Flow deciles, the biggest premiums happen outside of the United States. In fact, the largest premium can be seen in emerging markets where companies that generate more cash are better suited to withstand market downturns. We want to emphasize just how valuable P/CF ratio analysis can be as a tool in planning for American Electric Power employees' and retirees' retirements.

The Retirement Group is a nation-wide group of financial advisors who work together as a team.

We focus entirely on retirement planning and the design of retirement portfolios for transitioning corporate employees. Each representative of the group has been hand selected by The Retirement Group in select cities of the United States. Each advisor was selected based on their pension expertise, experience in financial planning, and portfolio construction knowledge.

TRG takes a teamwork approach in providing the best possible solutions for our clients’ concerns. The Team has a conservative investment philosophy and diversifies client portfolios with laddered bonds, CDs, mutual funds, ETFs, Annuities, Stocks and other investments to help achieve their goals. The team addresses Retirement, Pension, Tax, Asset Allocation, Estate, and Elder Care issues. This document utilizes various research tools and techniques. A variety of assumptions and judgmental elements are inevitably inherent in any attempt to estimate future results and, consequently, such results should be viewed as tentative estimations. Changes in the law, investment climate, interest rates, and personal circumstances will have profound effects on both the accuracy of our estimations and the suitability of our recommendations. The need for ongoing sensitivity to change and for constant re-examination and alteration of the plan is thus apparent.

Therefore, we encourage you to have your plan updated a few months before your potential retirement date as well as an annual review. It should be emphasized that neither The Retirement Group, LLC nor any of its employees can engage in the practice of law or accounting and that nothing in this document should be taken as an effort to do so. We look forward to working with tax and/or legal professionals you may select to discuss the relevant ramifications of our recommendations.

Throughout your retirement years we will continue to update you on issues affecting your retirement through our complimentary and proprietary newsletters, workshops and regular updates. You may always reach us at (800) 900-5867.

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