Portfolio Allocation Using Free Cash Flows and Other Methods

Abstract

There are many ways to allocate money invested in shares of common stock within one’s portfolio. The traditional and best known allocation methods are price-weighting, market capitalization-weighting, and equal-weighting. Of these three traditional allocation methods, we find that equally-weighted portfolios performed the best. More recently, attention has been focused on “fundamental weightings” which use financial statement items such as sales, total assets, net income, leverage, EBIT, and free cash flows to weight stock portfolio investments. Using a well-known set of stocks, this research provides insight into the relative advantages of using some of these alternative portfolio allocation methods. This study found that using free cash flows to weight portfolios was the only technique that outperformed equally-weighted portfolios and provided the investor with positive, statistically significant returns. It was also found that when using free cash flows to weight the portfolios, levels of free cash flows were more important that trends.