Value Series II: Northrop Grumman Employees Can Use the P/CF Ratio to Find Value

For Northrop Grumman employees building a Retirement strategy, focusing on undervalued stocks with a high Price-to-Cash Flow ratio can be a useful tool to improve portfolio performance and plan for the future, 'says [Advisor Name], a representative of The Retirement Group, a division of Wealth Enhancement Group.

'As market volatility continues to mount, Northrop Grumman employees should look for investment strategies that reward cash flow more than traditional earnings to help them achieve their long-term Retirement goals,' says [Advisor Name], a representative of The Retirement Group, a division of Wealth Enhancement Group.

In this article we will discuss:

1. Importance of Price-to-Cash Flow ratio in the evaluation of investment opportunities.

2. Long-term returns how value investing outperformed glamour investing.

3. Role of Price to Cash Flow ratio in retirement planning for Northrop Grumman employees & retirees.

Given current market volatility, we think now is a good time to revisit important value metrics with Northrop Grumman employees and retirees in our four-part series. Part two of this four part value series will examine the Price-to-Cash Flow ratio. But sometimes investors want to beat the market. Those investors should consider the following proven strategy that some great investors have used.

Value investors learned how to beat the average annualized returns of the S&P 500 decades ago - and many have decades of track record to prove it. The most famous value investor is obviously Warren Buffett, but so are Benjamin Graham, David Dodd, Charlie Munger, Christopher Browne and Seth Klarman. This style invests in four metrics that define a value investment. These are the Price-to-Earnings Ratio, Price-to-Cash Flow Ratio, High Dividend Yield and Price-to-Book Ratio. These metrics are strong indicators of undervalued security, as you will see. These cheap Northrop Grumman securities regularly beat the market. How they affect investing depends on some characteristics and how their investment returns are correlated.

Today we examine the Price-to-Cash Flow ratio (P/CF) as a tool for planning for the retirements of Northrop Grumman employees. Many feel that using cash flow rather than accounting earnings paints a more complete picture of a company's business performance that may help with investment decisions and investment performance. We understand researched solutions are important to Northrop Grumman employees. Below are the results of two Fama and French [1] backtests of cash flow yield (the inverse of P/CF ratio) data from 1951 to 2013. As of December 2013, the sample had 2,526 firms (Carlisle-PCF, P2). The value decile had the 269 stocks with the highest cash flow yield and the glamour decile had the 311 with the lowest cash flow yield. The glamour stocks average USD 4.74 billion in size and stocks are worth USD 4.80 billion. (The average is skewed by the largest companies. In context, the smallest company is worth USD 272 million today (much smaller than average but still investable for most investors).

Stocks having negative cash flow were excluded. Portfolios are formed June 30 and rebalanced annually. In this backtest, the two portfolios are weighted by market capitalization, so bigger firms drive the portfolio performance more and smaller firms less. Here the value decile has returned 16.7 percent compound (18.6 percent in the average year) versus 9.3 percent for the glamour decile (11.5 percent in the average year) (Carlisle-PCF, P3) This is because the value portfolios generated more cash flow per dollar invested compared to the glamour decile. 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 is higher but never lower. The rolling average is the annualized mean return for each year-long period (sometimes called a 5-year rolling return) As we noted above, value's outperformance over glamour is not a historical anomaly.

Taking just the period from 1999 we see that even though the return is lower than the long-term average, value has remained the better bet. Since 1999, value outperformed glamour 8.7 percent compounded and 6.2 percent in the average year (Carlisle-PCF, P7) Possibly the popularity of simple value strategies has contributed to lower returns recently. I think it's because the market is still working off the massive overvaluation of the late 1990s Dot Com boom. We think a value-based strategy is best for Northrop Grumman employees and retirees Market capitalization-weighted returns can be used to show that the outperformance of value over glamour is not due to value portfolios with smaller stocks. They mean absolutely nothing unless you're running an index or hugging an index. It is easiest to just weight all positions equally in a portfolio. (If we are prepared to take a little more volatility in exchange for a little extra return, we can also Kelly weight [2] our best ideas). Kelly Weighting is based on the Kelly Criterion - a formula for determining what percentage of capital should be invested in each trade to achieve maximum long-term growth.

There are two parts to the formula (Kelly% = W-[(1 - W)/R]: the winning probability factor W and the win/loss ratio R. It is a winning probability that the probability trade will result in a positive return. The win/loss ratio is the sum of the positive trade amounts minus the negative trading amounts. Its result will tell investors what percentage of their total capital they should invest in each investment. Equal weight return statistics for cash flow yield are given below. The value returned 20.7 percent compounded (23.8 percent on average) against glamour's 9.3 percent compounded return (12.5% on average) in the equal weight backtests (Carlisle-PCF, P9).

And you might notice that there is a tiny advantage for the cash flow yield's value decile over the earnings yield's value decile: 20.7 percent to 20.1 percent. We'll examine the impact of that small cash flow win in coming weeks. Again the value portfolios generate more cash flow than the glamour portfolios - 24.6 percent versus 4.1 percent in the glamour portfolios. We saw last week that the average cash flow yield of the equally weighted value portfolio is a bit lower than that of the market capitalization-weighted portfolios.

This means that over the whole period, bigger stocks were generally cheaper than smaller stocks to buy cash flow. Not always, of course, but it is interesting nonetheless. In equal-weight portfolios, value has beaten glamour since 1999 by 11.1 percent compounded and 10.0 percent in the average year. Since the value portfolios generate more cash flow than the glamour portfolios (on average 24.6 percent versus 4.1 percent in the glamour portfolios) we value research just as much as Northrop Grumman employees and retirees do (Carlisle-PCF, P10). We saw last week that the average cash flow yield of the equally weighted value portfolio is a bit lower than that of the market capitalization-weighted portfolios.

This means that over the whole period, bigger stocks were generally cheaper than smaller stocks to buy cash flow. Not always, of course, but it is interesting nonetheless. In the equal-weight portfolios, value has outperformed glamour Since 1999 by 11.1 percent compounded and 10.0 percent in the average year (Another study analyzing the P/CF metric is listed below. Brandes study In a Brandes Research Institute Study, exhibit 6 shows global all-cap results across three price metrics. They confirmed a consistent premium across all metrics. Focus is on P/CF ratio and outperformance in decile 10 value stocks. The smallest outperformance between decile 1 glamour stocks and decile 10 value stocks is seen in P/B measurement, where the average outperformance was 7.1% (Brandes, p. 8) In the same Brandes study they tracked Price-to-Cash Flow in the U.S., Non-U.S. and Emerging Markets. In rolling 5 year annualized returns of price-to-cash flow deciles for 1980-2014, the lower price-to-cash flow deciles outperform the higher Price - to-Cash flow deciles.

Results are shown on the graph 'Appendix C: Figure 4' Using P/CF Deciles Findings by Regions. ' Even though all of the lowest Price-to-Cash Flow deciles outperform the high Price-to-Cash Flow deciles, the biggest premiums occur outside of the United States. Actually, the biggest premium is found in emerging markets where companies that generate more cash are better positioned to weather market downturns. This highlights how useful P / CF ratio analysis can be in planning for Northrop Grumman employees' and retirees' retirements Currently the average Price-to-Cash Flow (P / CF) for the stocks in the S&P 500 is 13.9.

But like the P/E ratio, any value below 15 to 20 is generally good. A study from Zach's confirms this. According to their testing, a P/CF of 0-10 delivered the best result (17.1% in 10 years). The second best was 10-20, up 10.2%. But at + 30, the odds are stacked against a loss (-2.8%). And over 40, the odds are even greater - -6.9%. You can see that low-price-to-cash-flow stocks outperform high-price-to-cash-flow stocks The Retirement group is a national group of financial advisors. We only plan for and design retirement portfolios for transitioning corporate employees.

And each representative of The Group has been hand picked by the Retirement Group in select cities throughout The United States. Each advisor was screened for pension expertise, financial planning experience and portfolio construction knowledge. TRG believes in teamwork to find solutions to our clients' problems. A conservative investment philosophy guides the team in constructing client portfolios with laddered bonds / CDs / mutual funds / ETFs / Annuities / Stocks and other investments. They handle Retirement / Pensions / Tax / Asset Allocation / Estate / Elder Care issues. This document uses different research tools and techniques. All attempts to estimate future results involve assumptions and judgments and are therefore only tentative estimates.

The law, investment climate, interest rates and personal circumstances will all change and will affect how accurate our estimations are and how appropriate our recommendations are. Such a plan requires ongoing change sensitivities as well as constant re-examination and alteration of the plan. So update your plan a few months before your expected retirement date and do an annual review. Nothing contained herein shall be construed as an attempt by the Retirement Group, LLC or any of its employees to practice law or accounting. We look forward to speaking with any tax and/or legal professionals you may select regarding the implications of our recommendations. Through your retirement years we will continue to update you on issues affecting your retirement via our complimentary and proprietary newsletters, workshops and periodic updates. Or call us at (800) 900-5867.

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