Financial markets have soared since the beginning of the year despite the looming recession in Europe and the US. The reopening of China and the resilience of the labour market give hope for a soft landing of the economy. In this environment, it is advisable to remain cautious and to strengthen investments in quality stocks, i.e. those that are capable of gaining market share and generating stable cash flows over the long term.
A positive cash flow indicates that a company's liquidity is increasing, allowing it to cover its obligations, reinvest in its business, return cash to shareholders, pay expenses and protect against future financial contingencies. Companies that have a high degree of financial flexibility have more room to manoeuvre when selecting profitable investments. They also fare better in a recession.
According to an internal quantitative study by Atlantic Financial Group, it has been shown that the performance of a stock is largely explained by the company's ability to generate cash (see Fig. 2).
PE is also a ratio that is closely followed by investors, but it is less relevant in explaining the performance of the stock. The difference is probably due to the resilience of a company that is able to generate free cash flow throughout the economic cycle even if it has a negative net income. Cash flow will obviously be reduced if the company is no longer generating profit, but it can remain positive thanks to good working capital management, for example. These evolve in line with inventory levels or the timing of payments to suppliers, among other things. Cash flows therefore truly reflect the quality of the company's management, its long-term vision and above all its ability to react to exogenous factors.
The cash flow statement helps to understand where the company's cash comes from. The company can generate cash in three ways: 1) through its current operating activities; 2) through its investments or 3) through financing operations. Companies will therefore make strategic choices to generate cash and optimise their return.
Cash generated through financing transactions must be carefully analysed as interest rates rise. The situation is more complicated for companies that do not generate profits or cash flow due to lack of revenues and whose valuation is based on discounted future cash flows. This is the case for many companies whose business depends on recent technology, or which are still in the research and development phase, such as biotech companies. The rise in interest rates penalises them both in the valuation of their cash flows and also because of the rise in financing costs as equity financing becomes more complicated. The price of these companies often deteriorates below their book value (patents, etc.). They then become potential targets for cash-rich companies. Finally, highly leveraged companies such as REITS in the US may continue to underperform under the weight of debt service while real estate values deteriorate (see Fig.3).
However, what ensures a great deal of stability for the company is its ability to generate cash through its operational activity. To do this, the company must be able to win market shares from its competitors or set prices that guarantee stable margins.
Sectors capable of setting prices include the pharmaceutical sector (e.g. Merck, Pfizer, Roche or Novo Nordisk) or the utility sector (e.g. Engie, NextEra). Although largely regulated, these two sectors are indexed to inflation. Finally, the price of drugs is protected by patents, which guarantees pharmas a comfortable margin.
The luxury sector is able to increase prices without affecting sales volumes. The staples sector also benefits from low price elasticity of demand, which ensures stable margins over time and good visibility on future cash flows. Margins start to grow again as soon as inflation has peaked, as companies have already passed on increases in raw material prices and wages in the price of finished goods.
Finally, companies in a monopoly or oligopoly situation are the most capable of setting prices. The most notable of these are Microsoft, Apple, Alphabet and Visa in the United States and Hermès, Louis Vuitton, Essilor Luxottica, L'Oréal and Pernod Ricard in Europe (see Fig.4).
If the company cannot maintain its market leadership and grow organically, mergers and acquisitions will allow it to increase its revenues and potentially its margins through economies of scale. Financial flexibility is therefore essential in times of crisis and often proves to be a trend accelerator. Indeed, well-managed companies will have the necessary funding to pay their shareholders (see Chart of the Week) or interest on their debts, but they will also have the cash available to acquire companies in difficulty, offering new growth opportunities.
In a deteriorating macroeconomic environment, the selection of quality securities becomes essential. As with an investment portfolio, the cash available in times of uncertainty makes it possible to limit losses on the one hand, and, above all, to take advantage of opportunities that arise in the event of a panic on the financial markets.