Economic Update: December 15, 2009
By Mark Oelschlager, CFA
Portfolio Manager
Given all that is happening in this country – high unemployment, ballooning budget deficits, declining housing values, consumer deleveraging, a weakening dollar, increasing federal regulation of business, prospects for higher taxes, etc. – it is easy to be worried. And the way people convey that worry, in large part, is through their opinion of the stock market.
The value of any security is the discounted value of the sum of its future cash flows. So the value of a company, or its stock, is the value of the future cash flows that accrue to its owners. Sometimes it is easy to forget this, as there is a tendency of people to think of stocks as speculative pieces of paper that vary, sometimes wildly, in price. But if one focuses on what American businesses are currently generating, in terms of profits or cash flow, and the price at which one can currently buy a piece of that future stream of profits, it is much more difficult to be bearish.
Many financial analysts, including ourselves, generally prefer to look at free cash flow (the cash flow that is left for owners of the business after all expenses and capital expenditures are paid) rather than earnings because the latter is more easily manipulated. As stated earlier, the value of a firm is the sum of its future cash flows. Free cash flow (FCF) yield is a company’s free cash flow divided by its market value. It essentially tells one what yield he or she would receive, based on current FCF, if he or she owned the entire company. As an example, eBay, over the last four quarters, generated $2.27 billion in FCF. The company is currently valued by the market at $29.4 billion. This means eBay has a FCF yield of 7.7%. So if one purchased the entire company, he or she would be able to earn 7.7% on the investment, at least at the current rate of FCF generation.
What about the overall market? Our friends at Empirical Research Partners tell us in their December 8 research report that based on a third quarter run-rate, large and small-cap stocks are yielding about 8%, on average. This is an impressive number, but there are a couple footnotes that make it arguably even more impressive. First, these FCF yields for the market, eBay, and any other company one examines are being calculated during a time when the economy has been weak and sales down. Most businesses that suffer a decline in sales, as many have recently, suffer even greater declines in profitability because they have at least some fixed costs. When sales start to rise again, profitability should increase, driving even greater free cash flow. In other words, the 8% FCF yield of the market may even be understated (on the other hand, as conditions improve, capital expenditures are likely to rise, thus partially mitigating the improvement in free cash flow).
The second footnote is that alternative investments (Treasury bonds, corporate bonds, CDs, etc.) are offering yields that either pale in comparison to, or don’t offer the traditional premium to, the free cash flow yields of stocks. The current trailing four-quarter FCF yield on stocks is 6%. Remember though that this represents cash flow generated during one of the worst economic climates in the last 100 years. Even so, according to Empirical, this 6% FCF yield puts stocks at parity with the yields of Baa corporate bonds, something not seen since the 1950s. Another way to look at it is that over the last 56 years, the FCF yield of stocks (based on the trailing four quarters) has, on average, been half that of Baa corporates (whereas now stocks yield the same). Interestingly, despite all this, household bond holdings as a percentage of discretionary financial assets are at the upper end of their 40-year range, and investors continue to allocate new money in that direction.
Despite considerations for safety, the reason stocks typically yield less than bonds is that there is potential for growth. With a bond, you know the amount you are going to receive. With a stock, not only is there potential for FCF to grow over time, growth is likely. But right now investors are focused on preservation of capital, given the ups and downs of the market in recent years.
This commentary should not be construed as a wildly bullish assessment of the market, but rather a look at the other side of the bearish commentary that is prevalent. It also is not a dismissal of the aforementioned list of concerns; we talk about those issues on a regular basis and factor them into our investment decisions. But we believe it is important to remember what ultimately determines the value of publicly traded companies (and thus stock prices), and also what the alternatives are currently offering. Unless one has reason to believe that corporate free cash flow generation is likely to significantly decline from here, we find it difficult to be bearish at current prices.
This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. No mention of particular securities should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities.
Mutual fund investing involves risk including loss of principal.