With Stocks, Outflows Are Your Friend

A great deal of attention is focused on growing tech companies like the “FAANG” stocks. Obviously, businesses can generate great returns just by growing in size. More income leads to a higher stock price. In times like these, it’s tempting to think that building a huge market cap is the only successful business strategy. But it’s worth remembering there’s another source of shareholder return.

Fund Flows vs. Stock Flows

With equity funds and ETFs, inflows generally cause a rise in stock prices. When investors pour cash into funds, the fund managers must put that cash to work by buying stocks. The resulting increase in demand causes stock prices to rise. Inflows are a good thing, outflows are bad. Simple concept, right?

But inflows into equity funds do not mean there are inflows into stocks. When an equity fund buys a stock on the open market, cash is exchanged with the seller. Unless there are newly-issued shares, there is no net inflow to the business.

Take a look at the below chart from Bloomberg. It shows that the biggest buyers of stocks recently have been corporations making repurchases:

Like inflows into equity funds, buybacks usually cause stock prices to rise. At first glance, one might think all these buybacks represent a cash inflow. Like an investor buying shares of a mutual fund, aren’t buybacks just inflows into the stock?

Actually, no. A company uses cash to purchase its stock from other holders. Those holders receive cash, and the company effectively “retires” the shares from the public market. With a buyback, cash comes out of the company’s balance sheet and into the hands of investors. Buybacks are cash outflows from a stock.

People sometimes assume a rising price means money is flowing into a stock, and a falling price means money is flowing out. But every trade has a buyer and a seller. The price movements of a stock do not represent flows into or out of the business. The stock market can continue to rise while cash is flowing out.

And for shareholders, well-timed cash outflows can be very, very good. Some of the most consistent, highest-performing stocks in the last century have delivered returns through cash outflows. Take a look at this chart of Altria’s stock price (white) and its shares outstanding (green):

From March 1990 to today, billions of dollars in cash flowed out of the company. Altria paid consistent, rising dividends, and simultaneously reduced its share count by 32% through repurchases. The market cap grew by 243%, but the total return for investors was 9,095%. By comparison, the S&P 500 returned 1,161% over that time.

This is not an endorsement of Altria’s products (tobacco) or its stock going forward. But it’s worth remembering that growing a huge market cap, as the FAANG stocks have done, is not the only way to produce gaudy shareholder returns. Sometimes companies just know when to push cash in your pocket.

Systematic vs. Discretionary Decision-Making

Corey Hoffstein shared some of his thoughts on investment philosophy this week. He explains his preference for systematic over discretionary approaches to investing. Because “any disciplined approach can be systematized,” he believes, there’s little reason rely on a discretionary manager who could break from discipline. Systematic approaches can be back-tested and applied to hypothetical scenarios, he argues, so there is a more robust track record to analyze than with a discretionary manager.

I sympathize with this idea generally, but as always, it depends. Some type of disciplined, systematic process is crucial, but the question is the best place to draw the line.

Of course, any systematic approach or model is first created by a discretionary process. Even if the model is built with a sophisticated piece of software that can self-optimize, it was originally programmed by a human, and in most cases, humans continue to troubleshoot and monitor it. It is up to humans to decide when to modify a systematic strategy, and when to abandon one rules-based approach for another.

In the same sense, most discretionary managers incorporate systematic techniques into their process. This could be a simple stock screen or an advanced model – but if the manager makes idiosyncratic, overriding decisions, it’s a discretionary approach.

In many ways, these debates between systematic and discretionary investors are a matter of cognitive style. Different people think differently, and there are successful investors in both camps. My view is that the key is knowing yourself, your strengths, and more importantly, your weaknesses. The first section of this piece by Cliff Asness describes how smart people sometimes speak in “different languages” when it comes to investing.

Personally, I prefer a discretionary approach, using rules-based techniques as decision tools. I’m skeptical of many back-tested or stress-tested systematic approaches, but not because I think they can’t work. It’s because: (1) from my perspective, the “arms race” between quantitative strategies means any back-tested approach may be ineffective in the future. And (2) because systematic approaches can miss or misinterpret the extremes of human behavior. There are great quantitative investors, but I recognize my lack of skill in that domain.

As with many other choices, the “best” answer is probably different for different investors. As Asness writes, quantitative and qualitative investors agree on a great deal, they sometimes just speak in different languages.