U.S. corporate profit and cash flow performance has been a key to the favorable gains achieved for the domestic stock market. Third quarter profitability was impressive and is an important reporting season given companies traditionally provide more commentary on the upcoming calendar year. October and November are the months that both public and private companies typically prepare their upcoming estimates for sales, expenses, earnings and cash flow. Interestingly, mentions of recession during earnings calls have dissipated and the often-used term “soft landing” has gotten more mentions than “hard landing.” A soft landing for the economy, meaning no recession, would certainly be welcome, however a bumpy landing is still a distinct probability. For the time being, corporate balance sheets and profit margins remain quite healthy. For households, their balance sheets are in better-than-average condition and the often-discussed health of the U.S. consumer supports strength in spending.
Corporate cash flow is one metric I believe investors should focus on. The chart below shows the long-term case for U.S. stocks backed by favorable free cash flow growth and the accompanying growth in dividends. In the last twenty years, U.S. companies have been better skilled at free cash flow generation. With that free cash flow, the best companies are adept at capital allocation for their shareholders. That can include increasing dividends paid, share repurchases, increased capital spending, mergers and acquisitions and retaining the cash for future growth. As a testament to better free cash flow and capital allocation decision making, the S&P 500 Index has achieved an annualized total return of +11.1% (from 12/31/2002 through 10/31/2024).
Fortunately, we believe the next two years are likely to witness high single-digit growth in U.S. companies’ free cash flow and dividends per share. This could become even more important, acknowledging that current market valuations are getting more expensive following stock price gains over the last year.
S&P 500 Index: Dividends & Free Cash Flow Cumulative Growth
Now that the election is over, investment focus will importantly return to identifying companies that create shareholder value even when Washington policy is still largely uncertain. While the outcome of the election is now known, policy, including spending, taxes and regulation are still uncertain. Companies that are good capital allocators transcend Washington politics for creating shareholder value.