We live in a yield-obsessed era.
Whether it'sdividend yields,junk bond yields or lowly
governmentbond yields, investors seek yields in every corner of
But many overlook the most important type:free cash flow yield .
It's a simple yet powerful measure that points to the market's
top bargains. And you should measure eachstock in your portfolio
against this underappreciated metric.
You can figure out this yield by identifying a company's annual
free cash flow (which is its operatingcash flow minus itscapital
spending) and dividing it by the company'smarket value . For
example, a company with $50 million in free cash flow and a $1
billion market value has a 5% free cash flow (FCF ) yield ($50
Most companies in the S&P 400 (a mid-capindex ), S&P 500
and S&P 600 (small caps) have FCF yields below that 5%
threshold, yet any time you see a figure that's higher, it's a
certifiable value. In recent years, I've cited
Wal-Mart Stores (
as an example of a compelling FCF yield. The giant retailer has
stumbled during the past half-decade, but whenever its stock
falls out of favor, value investors have swooped in and
purchased, thanks to that solid FCF yield.
Why is free cash flow so important? It's the only way you can
know whether a company is adding value and building upcash
levels, even after capital spending has been taken into account.
Any company with $100 million in profits and $200 million in
capital spending is bleeding cash, not building it.
The double-digit yielders
Yet 5% is impressive though unspectacular when you consider that
44 out of 1,500 companies noted in those S&P indexes (400,
500, 600) sport FCF yields in excess of 10%. In this multi-part
look at companies with high FCF yields, I'll look at the best
small caps,mid caps andlarge caps . First, let's look at the
A quick screen of small capswill help us pin down 22 companies
that sport FCF yields above 10%. In fact, a handful of them have
yields above 20%, which is remarkable. But looks can be
deceiving. Some of these firms managed to generate solid free
cash flow in 2012, but their longer-term track record is spotty.
I've run through the list of 22, eliminating any firms that
haven't had positive free cash flow for three straight years, and
narrowed the list considerably.
Strong Small-Cap Free Cash Flow Yields
A few of thesestocks appear to sport FCF yields that are too
good to be true. So you need to see if they are sustainable.
InteractiveBrokers Group (Nasdaq: IBKR)
. The provider of online trading services has been remarkably
profitable, though it has ared flag: Free cash flow has fallen
from $1.6 billion in 2010 to $474 million in 2012.
Some of the drop is attributed to falling interest rates, as
Interactive must charge lower rates for themargin loans it
provides to clients. Yet the primary challenge to thebusiness
model has been in its market-making business (market makers hold
aninventory ofshares in certain stocks and buy and sell them to
investors according to demand).Profit margins for all market
makers have come under pressure in recent years, thanks to the
advent of other trading platforms such as electronic
communications networks, which are increasingly favored by
manymutual fund andhedge fund managers.
Yet even as the market-making business (which accounted for
one-third of profits in 2012) will likely come under further
pressure, the online brokerage platform (which was recently
ranked first by Barron's in its annual survey) looks set to
deliver solid free cash flow as the base of assets managed by
customers has been rising at 25% annually, exceeding $30 billion.
That should help to generate higher margins once interest rates
rise. Even if Interactive's annual free cash flow falls to $200
million in coming years, its stock is a compelling bargain.
CalamosAsset Management (Nasdaq: CLMS)
This firm provides asset management services to institutions and
high-net-worth individuals. Its recent financial performance has
been underwhelming in recent years, thanks in part to a
conservativeinvestment approach that was out of sync with thebull
market during the past four years.
Still, asset management is a steady and profitable business, and
Calamos has generated at least $100 million in free cash flow in
each of the past nine years.
- Is buying back shares.
- Consistently generates a return on assets above 20%.
- Has solidinsider buying.
- Has been steadily boosting its dividend (which now yields
more than 4%).
- Trades just above tangiblebook value .
With those metrics in place, along with the considerable FCF
yield, value investors are bound to takenote .
Over the next few days, I'll be profiling mid- and large-cap FCF
yielders as well.
Risks to Consider:
The companies on the table above have generated meager or
even negativerevenue growth in recent years, and a downturn in
the U.S.economy would make it hard for them to generate a revenue
Action to Take -->
This is an exercise that should apply to many companies in your
portfolio. If a company is largely mature, then it should be
expected to generate solid free cash flow tooffset the maturetop
line characteristics. The only exception is younger, growing
companies that have solid reasons to hike capital spending now
forsales andprofit growth down the road, a theme that I discussed
in this column.
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