Strategy note

Cash flow is king

A new strategy note from Chief Market Strategist Troy Gayeski

Troy A. Gayeski
November 28, 2022 | 8 minute read

As the latest bear market rally of 2022 continues, let me reiterate the main Galactic Mean Reversion survival tips for advisors and their clients:

Protect capital: Don’t be a hero.
Don’t chase bear market rallies in equities or fixed income: Use them as an opportunity to lighten up on beta and duration.
Prioritize economically resilient cash flows and total returns.
Roll up the capital structure: Lock in gains, improve income and total return, and minimize downside risk by moving up the real estate capital structure.
Focus on strategies in the northwest quadrant of the efficient frontier1: For the majority of your capital allocation, pursue strategies that offer a low risk of loss and low volatility. Finding strategies that have a fighting chance to generate mid-to high-single digit returns are like an oasis in the desert.
Don’t fight the Fed, high five the Fed: Focus on high quality floating rate assets.
Fight inertia: Embrace democratized alternatives.

However, we rarely meet investors who will—or even should—put their entire portfolio in alternatives or cash (even in today’s choppy, sloppy, messy environment). So, where should investors focus the riskier assets in their portfolios? Well, let us revisit the concept we first highlighted in our first strategy note of 2022: Cash flow is king. So, what does that mean in the current market environment?

  1. Whether an investor is analyzing a security (debt or equity), a sector, a geographic region, an illiquid asset or a strategy, cash flows historically tend to be much more resilient than market prices/valuations. Also, cash flows may be more durable in market dislocations or valuation adjustments (see Galactic Mean Reversion) than investments that are more focused on events, growth or transformative change with little to no cash flow.
  2. There are certainly environments like 1999 and 2021, where capital appreciation is king, or also known as green light, go environments. But guess what? Calendar years 2022 and 2023 (or orange light, extra caution environments) aren’t one of them!
  3. In strategies with high levels of cash flow, an investor does not rely on price appreciation to generate attractive returns.
  4. If cash flow levels are high enough, investors may potentially experience some degree of price declines and still have a positive outcome and/or may potentially break even over a reasonable time period.
  5. For strategies that generate cash flow, theoretically nothing needs to happen to generate a positive return. If prices don’t go up? Who cares. No event to drive value creation? No big deal. Market participants don’t buy what you own? No worries. You just need the cash flow to be high enough to offset price declines and/or realized losses caused by defaults (if the strategy is focused on credit).
  6. Strategies that have high levels of durable cash flow and reasonable prices/valuations tend to be positively convex (potentially more upside than downside) even in more volatile market environments because the cash flow acts as a buffer to swing in price.
  7. However, if the cash flow is not sufficient to offset price declines during a bear market, an investor could suffer mark to market losses. Furthermore, if default rates and realized losses on credit investments exceed income, there could be a period of net asset value and market value/price decline.

For the segment of your portfolio and asset allocation where volatility and risk can be tolerated, cash flow is king. If you are willing to tolerate higher levels of volatility and risk, having a handsome level of cash flow paid out as income or a dividend is an advantage. Heck, if you are going to take risk in an environment like this, make sure you’re getting paid for it.

One additional point: Never underestimate the power of permanent or long-dated capital in order to generate more attractive absolute and risk-adjusted returns in any market environment and particularly one in a sloppy, choppy mess. Permanent capital allows the investment manager to take advantage of market dislocations and go after the best opportunities without looking over their shoulder to meet redemptions or outflows. As market liquidity has dried up since the regulatory reforms of the banking system drove proprietary trading desks and market makers out of business, price dislocations have become more common. It is challenging to maximize these opportunities in a fund structure, like a credit mutual fund or reasonably liquid hedge fund, because of the necessity for the investment manager to provide liquidity to investors at such short notice. In permanent capital vehicles, however, the investment manager can focus solely on maximizing client absolute and risk-adjusted returns. It’s also a heck of a lot easier to solely focus on what’s in front of you than constantly having to watch your back!

As the Galactic Mean Reversion rolls on, keep it simple for the segment of your portfolio where you can tolerate more risk and volatility in order to potentially generate higher returns over time. Focus on cash flow-generating strategies that have high levels of income, potentially trade at discounts to NAV, may continue to benefit from additional Fed rate hikes and can maximize the advantage of permanent or long lock-up capital.

Cash flow is king, long live the king!

  • The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are sub-optimal because they have a higher level of risk for the defined rate of return.

Investing in alternatives is different than investing in traditional investments such as stocks and bonds. Alternatives tend to be illiquid and highly specialized. In the context of alternative investments, higher returns may be accompanied by increased risk and, like any investment, the possibility of an investment loss. Investments made in alternatives may be less liquid and harder to value than investments made in large, publicly traded corporations. When building a portfolio that includes alternative investments, financial professionals and their investors should first consider an individual’s financial objectives. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be determined.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Troy A. Gayeski, CFA

Chief Market Strategist

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