Back to Main

This Ratio Reveals The Market's Top Bargains

By: StreetAuthority
Posted: 4/2/2014 3:30:00 PM
Referenced Stocks: FCF;EPS

With the ink dry on 2013 financial results, investors can get a fresh gauge on how companies fared over the past year.

#-ad_banner-#By and large, 2013 a very good year for corporate America, as profit margins hit all-time highs in many industries. Yet not every company manages to translate robust margins into cash in the bank. Many times, operating profits will be squandered and the actual free cash flow (operating cash flow minus capital expenditures) a company produces can be lacking.

The real stars of 2013 are the companies that focused on delivering peak robust free cash flow ( FCF ), which sets the stage for a set of shareholder-friendly perks that we refer to as Total Yield . A company with solid FCF can boost the dividend, buy back stock, pay down debt -- or all three. There's often even enough money left over for acquisitions.

Of course simply looking at FCF by itself isn't always helpful. Google (Nasdaq: GOOG ) , for example, generated an impressive $11 billion in FCF in 2013, but that's just a fraction of the company's $376 billion market value. Instead, it's wise to look at FCF in relation to a company's value. If you can find a company with a FCF yield (FCF divided by market value) in excess of 10%, it's invariably a solid value.

I went in search of great FCF yields among the stocks in the S&P 400, 500 and 600, eliminating any companies from contention that generated negative FCF in any of the past three years. I also excluded banks from my search, as many banks took steps to shore up their capital bases, which led to an artificially high FCF reading in 2013. What's left is 31 companies, nearly half of which are in the insurance industry.

Frankly, this is a great time to be focusing on insurers. These companies are performing well now, and are poised for even better days ahead. A firming economy will give them pricing power, and rising interest rates will help them earn more on their hefty cash balances.

Before I move on to other industries, I want to add another test to these insurers. Many of them are using their prodigious FCF for share buybacks, and I'm especially keen to see buybacks when shares trade below book value. The math on such buybacks is quite compelling.

Let's look at the top five insurers in terms of price-to-book ratios.

The fact that Reinsurance Group of America (NYSE: RGA ) trades for less than tangible book value and sports a 30% FCF yield makes this company one of the top bargains in the entire stock market.

Outside of the insurers, there are 17 other companies that sport double-digit FCF yields (again excluding any company that has generated negative FCF in any of the past three years).

To be sure, some of these firms' high FCF yields are due to repressed market values. Investors anticipate slow growth for them in coming years, and thus assign a low valuation to them. Hewlett-Packard (NYSE: HPQ ) , Xerox (NYSE: XRX ) and Sanmina (Nasdaq: SANM ) , for example, have all reached maturity, which has led growth-oriented investors to shun them. Still, each of these companies produces such powerful free cash flow that they are capable of being among the best Total Yield plays on the market.

My personal favorite on this list is Valero Energy (NYSE: VLO ) , simply because the economic backdrop for energy refiners will keep getting better as the U.S. pumps more crude oil.

Valero made a major capital spending push from 2008 through 2012, spending $12 billion to modernize and maintain its refiners. Annual capital expenditures (capex) have since dropped to around $2 billion, enabling FCF to surge. Valero appears poised for nearly $3 billion in annual free cash flow in the years ahead, and as a result, management is expected to continue to devote roughly $1 billion a year to buybacks, and at least $500 million towards dividends. Valero has also trimmed long-term debt roughly $2 billion over the past three years.

Lastly, Total Yield investors should give a close look to Iconix Brands (Nasdaq: ICON ) , which owns a wide range of apparel brands such as Starter, Danskin, Joe Boxer and Candies. Management has shown a remarkable knack for squeezing out FCF, which has risen for five straight years to a recent $231 million. That came on a base of sales of $432 million, which highlights the powerful economics of the company's brand licensing model.

Iconix spent more than $400 million on share buybacks last year, reducing the share count by more than 20%. A fresh buyback announcement in February should reduce the share count by double digits again this year.

Risks to Consider: Companies can get carried away in their pursuit of free cash flow. If they begin to underinvest in the business, then future returns may suffer. So it pays to dig into management's explanation of capital allocation resources, which is often found in the annual report.

Action to Take --> The greatest appeal of free cash flow is its transparency. It is free from the accounting gimmicks that can be used to distort metrics such as operating margins or earnings per share ( EPS ). As such, companies with solid FCF yields -- like H-P, Xerox, Valero and Iconix -- deserve a strong consideration from investors.