Value seen through the prism of free cash flow

What are we looking for?

Stocks in both Canadian and U.S. markets with the lowest price-to-free-cash-flow ratio – a key value metric in a mid-cycle economy.

The most valuable value

We are revisiting a screen we ran about 18 months ago, inspired by some of the research of Brian Belski, chief investment strategist at Oppenheimer & Co. in New York. Mr. Belski found that while all stocks are fairly closely correlated when markets tumble into recessions and then bounce back from their cycle troughs, there tends to be a lot more differentiation in performance once a recovery takes hold. At that stage, the best market performers are so-called "value" stocks – those that look relatively cheap based on any of a number of financial measures. (He said this low-correlation period can last up to three years from the end of a recession.)

He looked at nine of the most popular value metrics to determine which measure provided the best returns in these periods. On both an absolute and a risk-adjusted basis, a low price-to-free-cash-flow (P/FCF) ratio delivered the strongest outperformance.

We've replicated Mr. Belski's screen to see which stocks, both on the S&P/TSX composite and the S&P 500, have the lowest P/FCF scores. (We've also included the enterprise-value-to-EBITDA (EV/EBITDA) and price-to-earnings-growth (PEG) ratios for those stocks – the value measures Mr. Belski identified as delivering the second- and third-best returns, respectively, among the value measures he tested.)

What did we find?

Note that in an up-and-down year for stocks, many of the names generated by our screen – particularly on the Canadian side – have underperformed the broader market. Their low P/FCF numbers suggest these companies may have been unduly battered by the market's prevailing uncertainty, and may well be due to outperform once the unusual risks hanging over the markets dissipate.

At that point, the usefulness of this screen depends on where we are in the economic cycle. If we are on the brink of another recession, as some observers fear, then a value play such as P/FCF might not matter much – stocks are likely to all retreat together and subsequently rebound together.

However, a more likely scenario – particularly in Canada – is that we are coming through a lull in a two-year-old recovery – and that this value play remains intact.