New #ETF Insights Article from AAM Exchange Traded Funds - PATIENCE

By Lance McGray Jr. Managing Director, Head of ETF Product

?“The stock market is a device for transferring money from the impatient to the patient.” -Warren Buffett

Patience is one of the most underrated, yet most important traits of a successful investor. Unfortunately, in today’s high-tech and always connected society, instant gratification (instead of patience) has begun to permeate many aspects of our lives, including investing. A recent study highlighted the increasing impatience of investors where the average holding period of U.S. stocks fell from 8 years in the 1950s to less than 6 months in June 2020.1

However, more than just patience in isolation is required to be a successful investor. Afterall, one could patiently play the lottery every day of his/her life but the odds of winning the jackpot remain slim. As Warren Buffett often suggests, patience must be coupled with skill and effort.

This raises the question, “If an investment thesis is strong, why wouldn’t investors be rewarded immediately?”

To answer this, let us consider the concept of buying stocks that exhibit a combination of high free cash flow and dividend yield. Investors are becoming increasingly aware that free cash flow is an important metric that could potentially paint a more accurate picture than revenue and earnings. Indeed, common sense and academic literature agree that strong free cash flows and dividends should produce stocks with a strong risk-to-reward profile, particularly when you consider:

• Dividend-paying stocks outperform non-dividend-paying stocks by 1 to 2% more per month in declining markets than in advancing markets.2
• Higher free cash flow yield supports debt servicing/repayment as well as other obligations such as dividend payouts.
• Free cash flow may be a more reliable predictor of returns than earnings as it avoids misrepresentations by concentrating on the net cash flows from a firm’s true operating cycle. 3
• Stocks with high free cash flow yield are less likely to dilute shares or heavily increase debt to raise capital.

Expectation Hangover

If free cash flow and dividend yield offer such valuable insights that few other financial metrics can match, why has a high free cash flow plus dividend yield strategy not outperformed the S&P 500 in recent years?

A good idea often takes time to bear fruit. Consider some reasons why free cash flow and dividend yield may require patience in today’s market environment:

• A rapid rise in interest rates may lead to downward pressure on dividend stocks.
• Cap-weighted indexes have become increasingly concentrated in a few positions leading to a divergence of average stock performance from the benchmark.
• Investors have been focused on AI stocks which has led to the recent outperformance of large tech stocks.
• Value stocks have not been in favor in recent years.

Does this mean that investors should abandon sound investment principles that have been rigorously tested and chase the latest fad in the hopes of ‘striking it rich’? That hardly seems prudent.

A patient investor could consider that the cycle of interest rate hikes is either over or near its end. Lower risk-free interest rates may see a resurgence for higher dividend-paying stocks. With growth stocks at already elevated valuations, investors may turn their attention to value stocks once again. The benchmark might also abnormally underperform for a few years due to high concentration risk. This is especially possible if the AI frenzy subsides, and valuations normalize.

Furthermore, factor returns typically exhibit momentum. This means that when investors favor a certain style or set of factors, it may persist for some time. While this has created a performance drag on value in recent years, it also means that when value does come back into favor, it could outperform for a considerable time. A prudent investor would position himself ahead of time and not after the train has left the station.

Conclusion

To quote an often-heard expression in finance, Past performance does not guarantee future returns. This is typically used in the context of high trailing returns, but it could equally be applied to a strong investment idea that is taking a little longer to potentially produce greater returns than expected.

Waiting for something doesn’t mean it isn’t coming, but it does require a trait uncommon to most investors today – PATIENCE.

Sources:

1. https://www.weforum.org/agenda/2021/12/long-term-investing-decline/

2. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=687067

3. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2956671

4. https://rodneywhitecenter.wharton.upenn.edu/wp-content/uploads/2018/03/Juhani.pdf

This publication is provided for information purposes only. Unless otherwise stated, all information and opinions contained in this publication were produced by Advisors Asset Management, Inc. (AAM) and other sources believed by AAM to be accurate and reliable. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and best interests. All expressions of opinions are subject to change without notice.

The mention of any funds in this publication is not meant to be a recommendation to buy or sell.

Past performance does not guarantee future results. Investing involves risk, including the possible loss of principal.

The investment objectives, risks, charges and expenses must be considered carefully before investing. The Fund’s statutory and summary prospectuses contains this and other important information about the investment company, and may be obtained by calling 800.617.0004 or visiting www.aamlive.com. Read it carefully before investing.

Investing involves risk, including the possible loss of principal. Shares of any ETF are bought and sold at market price (not NAV) and may trade at a discount or premium to NAV. Shares are not individually redeemable from the Fund and may be only be acquired or redeemed from the fund in creation units. Brokerage commissions will reduce returns. To the extent the Fund utilizes a sampling approach, it may experience tracking error to a greater extent than if the Fund had sought to replicate the Index. Diversification does not assure a profit or protect against a loss in a declining market.

Definitions: Free Cash Flow represents the amount of cash generated by a business, after accounting for reinvestment in non-current capital assets by the company. Dividend Yield is a financial ratio that measures the annual value of dividends received relative to the market value per share of a security. S&P 500 Index is an unmanaged market capitalization weighted index used to measure 500 companies chosen for market size, liquidity and industry grouping, among other factors. It is not possible to invest directly into an index.

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