This Strategy Can Help You Beat the Market — At Lower Risk

By TradeSmith Research Team

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Years from now, if some Hollywood screenwriter wanted to craft movie script about the markets investors have been forced to navigate the last few years, the title would probably be “When Chaos Met Uncertainty.”

And I couldn’t disagree.

No sooner had we exited the COVID-19 pandemic than we were forced to deal with war, inflation, Washington catfights, economic uncertainty, whipsawing stock prices and technology dislocation.

Yes, Chaos is meeting uncertainty.

As investors, we can’t just run and hide. There are still opportunities out there. We just need to search them out.

And we need to shift the odds in our favor.

Today I want to show you one strategy that can help you do that — and list a few stocks that can fill the bill.

Free Cash Flow is King

At times of heightened uncertainty (as the old mantra tells us), Cash is King. Or, more specific to your investment choices, Cash Flow is King.

The fact is that numerous studies — plus my own real-time investing experience — clearly show that one of the best valuation measures you can find is “free cash flow (FCF) yield.”

Stocks with the highest FCF yield consistently produce higher risk-adjusted returns than any other valuation factor I know of — and beat the market overall.

Over the past 20 years alone, stocks with the highest free cash flow yields have beat the S&P 500 by an average of 7% per year, as you can see below.

That gives you an incredibly powerful edge — and one that can boost your investing results.

And it’s an easy metric to figure out on your own — even on the back of a restaurant napkin if need be. Here’s how.

Take the amount of free cash flow (FCF) a company generated (over the trailing 12 months, or TTM) compared to the total value of the business including equity and debt aka “enterprise value,” or EV.

Simple but effective, and even easier to figure with the aid of Microsoft Excel.

Here’s the hard evidence of just how effective the free cash flow yield metric can be for investors.

As the chart shows, large-cap companies with the highest FCF yield have consistently outperformed nearly every other valuation metric — and with much less volatility to boot. (Which is great for this uncertain stretch.)

You can see for yourself how well FCF yield stacks up against other, more popular valuation measures like Price/Earnings (P/E) and Price/Book (P/B) ratios.

Free cash flow yield consistently earns higher returns with far less chance of losses. It’s really no contest.

From 1991 to 2022, Russell 1000 stocks with the highest FCF yield returned more than 16% per year — with negative 12-month periods only 16% of the time.

The benchmark Russell 1000 Index, by contrast, returned just over 9% annually (just over half as much) and posted negative 12-month returns about 19% of the time.

Screening for Cash Flow Royalty

I recently screened for some high FCF yield stocks — creating a “watch list” to follow.

And here are two stocks that popped up on my screen — both of them in TradeSmith’s Health Indicator Green Zone.

The first is M.D.C. Holdings (MDC), with a recent FCF yield of 19.6%. Denver-based MDC is in the homebuilding and financial services businesses. Its shares are trading right around $42 right now, with a 52-week range of $27.04 to $43.66. The $2 dividend payout gives the stock a yield of 4.89%. And it delivered earnings and revenue beats with its first-quarter financial report, announced in early May.

A second high FCF yield stock is Humana Inc. (HUM) — with a yield of 10.7%. The Louisville-based healthcare provider is an industry heavyweight. It currently trades at about $522, with a 52-week range of $418.70 to $571.30. Its $3.54 a share dividend gives it a yield of about 0.7%.

Obviously, do your own research on each of these stocks, or if you’re an Ideas by TradeSmith subscriber, screen for others.

It’s a strategy that puts the odds in your favor.

Even in the Age of Uncertainty and Chaos.