Cash Flow Reigns King

Companies that can produce material amounts of free cash flow offer significant benefits to shareholders. But there is a key question to consider: has the free cash flow-producing capacity of companies changed over time?

One of the key drivers of value creation in the equity markets is a company’s ability to consistently produce operating free cash flow. This excess cash can be used to pay dividends, make acquisitions, repurchase shares or be retained by the business to improve the quality of the balance sheet, and companies that can produce material amounts of free cash flow offer significant benefits to shareholders. But there is a key question to consider: has the free cash flow-producing capacity of companies changed over time?

To answer this question, we did a comparison of the financial characteristics of the top 10 companies in the S&P 500 in 1990 versus 2020. In 1990, the internet age had yet to begin: 1990 was an important year not only because one of the most complete T. Rex fossils ever was found in South Dakota, but because it was the year a formal proposal for the World Wide Web was made. The following year, 1991, was when the Internet became available for unrestricted commercial use. Comparing 1990 and 2020 gives us a good basis by which to evaluate cash flow in the pre- and post-digital ages.

As a start, let’s compare the top 10 companies in the S&P 500 in 2020 versus in 1990. In 2020, seven of the top 10 are technology-related, including software, semiconductors, and social media. The top 10 in 1990 was a more diverse group: only one company (IBM) was technologyfocused, and IBM’s focus was on hardware products like mainframe computers. The other nine include a couple of oil companies, staples, and pharmaceutical companies.

When looking at the median statistics, there are some similarities but also striking differences. Median revenue growth is similar (15% in 1990 versus 14% in 2020)
although the spread of growth in 1990 is more consistent; in 2020, there are two material outliers: Amazon (38% revenue growth) and NVIDIA (53% revenue growth.)
Median margins proved to be much higher (26%) in 2020 than the 14% margins in 1990. This is largely a result of the technologyoriented companies producing high-gross
margins. Why? Because many technology companies’ products are highly-valued, yet inexpensive to produce — think Microsoft’s Office 365 — and many technology companies now dominate their area of focus, creating economies of scale and, often, greater pricing power.

The largest difference between the two periods lies in free cash flow production. The median free cash flow margin was 25% in 2020 versus 6% in 1990; put another way,
2020 constituents produced four times as much cash flow per dollar of revenue than their 1990 counterparts. (Note: we have used a simplified definition of operating free cash flow: net profits + non-cash expenses – capital expenditures. This allows us to get a sense of the business differences in the two eras). Low capital intensity businesses, along with higher margins, are key characteristics of the current period and contribute to the cash flow differences.


Comparison of free cash flow margin in 1990 and 2020 for selected companies

Note: For JPMorgan Chase net income margin was used as a proxy free cash flow margin
Source: Siblis Research, ETF Database Inc., Annual Reports (1990 data), Bloomberg.

Much has changed over the last thirty years. Cell phones had barely penetrated the market in 1990 and the internet was still in its infancy. Today, we are in the midst of the digital age with smart phones, artificial intelligence, and cloud computing. One important distinction about technology companies today is that their cash flow
production is substantial compared to previous eras, which is an important factor in driving value. In our view, cash flow is still king!

Thomas D. Sargent

Tom is the chief investment officer, a portfolio manager, and a member of the firm’s board of directors

Previously, Tom managed Conning & Company’s institutional investment management business, serving as a member of Conning’s executive committee, with responsibility for equity research, institutional sales, and equity trading. He was also a principal in Conning’s venture capital/private equity area. Tom was cited for his equity research expertise by Institutional Investor magazine in its “Best of the Boutiques” profile. He has achieved the designation of Chartered Financial Analyst®.


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