The report Australian Value Investing: Rethinking A Challenged Style advises investors to target stocks with low price-to-free cash flow (P/FCF) over stocks that are cheap on price-to-book (P/B) and price-to-earnings (P/E).
“There are three reasons for this,” Alliance Bernstein’s CIO of Australian equities Roy Maslen said.
“First, we believe that cash flows ultimately drive the value of companies over time. Second, our empirical research shows that the value risk premium from P/FCF is more attractive than that from P/B and P/E, both in terms of delivering higher returns and mitigating downside risk.
“Third, as a tool in the stock selection process, P/FCF can help sharpen the focus on a stock’s fundamental strengths and limit the risk of an investor placing too much hope on a re-rating of the stock’s price-earnings ratio.”
Alliance Bernstein argues in the report that P/B is no longer as effective as it used to be due to the proliferation of asset light business models that are unattractive from a P/B perspective despite their strong cash flows, and the potential for stocks that are cheap on P/B but which have stressed balance sheets to negatively impact equity holders during a downturn.
P/E is similarly challenged by the fact that companies are converting earnings into cash less often, delivering poor cash flows despite strong earnings.
The report warned that value investing is also threatened by the potential for technological disruption of past investments that make the book value of stocks less reliable as an indicator of future cash flows.
AB makes several other recommendations to enhance the viability of value investing, including identifying behaviours – such as optimism and overconfidence – that can lead to value traps, and stress testing portfolios against historical crises like the tech bubble and Black Monday in order to identify and mitigate macro risks.
