* Euro zone worries making markets volatile
* Free cash flow yield strategy offers safety
* FCF yield to outperform in 2013 - analysts
By Tricia Wright
LONDON, April 8 (Reuters) - European companies’ ability to generate cash is likely to be the main requirement for investors seeking shelter in equities during what many expect to be an economically weak second quarter.
Although equities are trading around 2008 highs, buoyed by the European Central Bank’s promise to defend the euro and ample central bank liquidity, the euro zone is in recession.
Analysts are cutting earnings forecasts and companies are writing down their asset values, making investment decisions based on either of these criteria risky.
This has prompted many investors to look at free cash flow (FCF) - what a firm has left after covering its running costs - for more certainty over likely returns.
Some investors see cash flow as a clearer measure than earnings of a company’s performance and sectors with high FCF have outperformed those made up of companies with less cash.
“FCF is likely to carry on outperforming while economic performance is weak in Europe and, more broadly, risk appetite is lower. We don’t see these changing materially this year,” Adrian Cattley, pan-European equity strategist at Citi, said.
Last month, economists polled by Reuters forecast muted growth in the second quarter and thereafter, but data releases since then have proved worse than expected.
In a low- or no-growth environment, companies with more spare cash are better able to jump on any opportunities for investment or expansion, boosting shareholder returns in the long run.
They are also well placed to maintain dividend payments even when earnings are weaker - an important factor for investors searching for returns in a climate of below-inflation sovereign bond yields and volatile markets.
“The more volatility you have, the more emphasis you want to put on things which are safe, and cashflows/dividends offer safety,” said Fabrice Theveneau, head of equity research at Societe Generale, forecasting a strong performance for the FCF-yield theme this year.
Sector performance is well correlated to FCF yield, or free cash flow divided by share price, with high FCF-yielding healthcare and consumer staples having jumped in the past year while basic resources underperformed.
The healthcare and consumer staples sectors have respective FCF yields of 5.9 percent and 5.1 percent, according to Thomson Reuters StarMine data, while the metals & mining sector has a FCF yield of minus 0.3 percent.
Earnings downgrades for European firms have outnumbered upgrades almost without a break since the start of 2012, according to Thomson Reuters Datastream, contributing to a solid share price performance from highly cash-generative firms.
The first-quarter earnings season, which kicks off this month, looks likely to maintain this trend, with analysts seeing earnings for European companies down by an average of 7.1 percent year-on-year, according to Thomson Reuters StarMine.
Against that backdrop, analysts at JPMorgan say stocks including artificial joints maker Smith & Nephew, drugmaker Bayer and cigarette group Imperial Tobacco could prove good bets as a result of their sustainable high FCF yields.
“We think the preference for FCF yield will hold as long as earnings revisions remain in negative territory and bond yields remain low,” JPMorgan strategists said in a recent research note. (Graphic by Tricia Wright, editing by Nigel Stephenson)