High FCF Yield Stocks; Returns from Business Results vs P/E Ratio Expansion
Examples of stocks that offer high FCF yields, where returns are earned from business results without requiring P/E expansion
We can simplify the value we receive from our stocks into three simple categories:
the cash we receive today (dividends and/or buybacks)
the cash we receive tomorrow (growth in that available free cash flow)
the change in the market’s valuation of that cash flow (e.g. the P/E ratio rising, or “multiple expansion”)
I call these the three engines of value, and any stock’s appreciation is a simple mathematical result of these factors.
Since the value we receive from these categories (whether measured in dollars or percentage returns) are fungible, I find it odd that investors tend to prefer prioritizing one of these engines over the other. All three can drive results.
“Quality” investors tend to prioritize returns on capital and the long term runway for growth, but ignore the impact that a shrinking multiple has to a stock’s performance — even the long-term performance. Costco is a world-class business, but trades at 55 P/E. Let’s say in a decade, the company replicates the exact same growth rate it had last decade (no easy feat given the larger starting base). If it trades at a reasonable 25 P/E (near its historical average), shareholders will earn just a 4% total annual return including dividends over the next 10 years. And if this multiple happens to come revert to its average in 5 years, the returns become negative over that period. A high enough price can lead to a risky investment even for the highest quality companies.
I think saying things like “we only invest in quality companies” is often a statement that does more harm than good to a portfolio over time, because it too often leads to the investor paying too much for these businesses collectively. The result here won’t usually be disastrous, but is often subpar.
“Value” investors often prioritize multiple expansion, and thus look for catalysts that might change the market’s perception of the business, causing its P/E ratio to rise. One thing growth investors might underestimate is that a rising P/E ratio can lead to a big tailwind even over a 10 year period. A stock that rises from 10 P/E to 25 P/E over a decade adds 10% per year to the annual return from the P/E ratio alone. If this company grows at just 4% and can pay out half of its earnings as dividends, the total return for these three engines will equal approximately a 20% annual return over a 10 year period. Not bad for a mature, 4% grower.
I see this undervalued-mature business theme play out frequently in large cap stocks when a business hits a rough patch. United Health Group (UNH) is a prime example right now; the health care industry is a large and important industry that I believe will be larger and just as important a decade from now; UNH has a wide moat in that industry and has issues which appear fixable over time, even if they take a few years. Ben Graham once said that the great thing about unpopular large caps is the market corrects itself very quickly if the company’s issues get resolved. I believe this could happen with UNH.
I also see this occur when a business has no specific issues but the industry is facing a headwind or perhaps there are fears of a recession. e.g. JP Morgan (JPM) is up nearly 3x in the last 3 years, a 44% CAGR for perhaps the world’s most well known bank. It was mispriced 3 years ago not because of company problems, but rather the fear that a recession would dent earnings in the near term. Stocks overreact to near term pressures even when those pressures have little impact on the total amount of future cash flows. JPM’s mispricing corrected itself rather quickly (as often occurs, as Ben Graham observed), but the results still likely would have been excellent even if the result took 5-10 years instead of only 3.
So, paying low prices obviously creates better long term results, but just as growth investors sometimes extrapolate current growth rates too far and almost ignore the P/E multiple; value investors sometimes spend too much time thinking about the multiple and not enough time on the value that can come from the long-term business results. One of the best features of a cheap stock is a high FCF yield, and as long as the stock stays cheap, the yield remains high and with proper capital allocation, this low growth cheap stock can turn into a compounder.
In this post I’m going to summarize a few stocks where our returns will largely be tied to the underlying business performance and given the cheap valuation of the stock and the plans to buy back shares, we don’t need the multiple to expand (the third engine), though I think that will eventually be the likely outcome. But not needing the market’s perception to change means we can get our returns through the underlying business — the cash the business produces. Just like one of Warren Buffett’s first business ventures — a pinball machine business that had machines in dozens of locations all over town — these stocks require low amounts of maintenance capital and produce lots of free cash flow, and our results won’t depend on whether the market appreciates them, what sell side firms decide to cover them, or what catalysts are on the horizon for increasing valuation levels. Our returns will just come from the cash that the business produces, like the Wilson Coin-Operated Machine Company in 1946.
Examples of stocks where high returns could come from the business results without any change in the market’s perception: