We’ve all heard that the value of a company is the present value of its discounted free cash flows. But I wanted to share something I found pretty interesting. What drives stock returns over the long run? It seems pretty clear that it is the growth in free cash flow per share.
As the tables below show, this one metric has a high correlation with the long-term growth in the stock price. We just mentioned what a DCF is so that may sound totally intuitive. Yet seeing the results are actually quite surprising to me. I say this in the context of the “random walk” stocks seem to follow day-to-day or even year-to-year. In sum, I think if you have high confidence that a company can compound its FCF/share at above market rates, you’ll probably do pretty well.
The second interesting thing is that I’m not showing starting EV/EBITDA multiple or P/E. All I’m showing is the FCF / share CAGR and the stock CAGR. So did the stock “re-rate” or “de-rate” it didn’t seem to matter in the small sample size.
A couple of notes (admittedly may be selection bias) I’m only showing names with long history and I’m trying to avoid some poor returning stocks with finance arms (Ford, GM, and GE) because that clouds FCF. Last, I’m using the end of 2019 to move out some of the COVID related movements. One thing this doesn’t capture either is dividends collected along the way, but that should be relatively limited in most cases (but I did exclude Philip Morris for this reason).
In closing, I would look for names that you have a high degree of confidence of growing FCF/share at a strong rate. Obviously, the normal investment checklist applies – does the company have a moat to protect those cash flows, does it have a long investment runway, is it in a growing industry, and is it gaining scale to compound cash flows? Clearly, this drives stock returns.
I think if you were to show more commodity names as well, it would show how hard it is to make money over the long term. Not only do commodities have to deal with the larger business cycle, but they often have their own cycles within whatever they are selling (e.g. gold, copper, TiO2, etc. can move around considerably year to year and decide a company’s fate).
I typically look for underappreciated, high FCF businesses that are shareholder friendly. As I was screening for new ideas, an old giant popped up – IBM. IBM is famous for buybacks. This is a personal opinion, but with so much focus on Google, Facebook, Amazon, Microsoft and Apple it seems as though no one even discusses IBM anymore.
Could this be a Microsoft-in-2011 moment? At that time, MSFT was trading at a P/E of 9-10x and was viewed as a slow, lagging behemoth, and certainly not exciting anymore… just a dividend paying stock. They got a new CEO after many years of Balmer and reignited excitement and ingenuity at the company. The rest is history.
IBM currently trades with a 4.8% dividend yield, 9.5x 2020e EBITDA and 10.1x 2020e EPS. And with IBM buybacks staying strong – it is essentially returning all cash to shareholders.
The business in total has not grown much, but does have some exciting segments like Watson (“Cognitive Solutions”) which is wildly profitable – in 2018, Cognitive Solutions had nearly 68% gross profit margins and 38% EBITDA margins…
Should we compare Microsoft then to IBM? Clearly over the same time frame as Microsoft, IBM has been floundering.
Cognitive Solutions is clearly an exciting segment, but at the end of 2014 the company did $93BN in revenue and $24.6BN in EBITDA. In the past 12 month, the company did $77BN in revenue and $16.6BN in EBITDA. Moreover, if we go back to the end of 2003, the company’s market cap was $161BN. When they reported Q3’19 results, IBM’s market cap was $120BN. Meaning after nearly 16 years, no real value had been created.
So what happened? What were the drivers of these abysmal returns?
Clearly, a significant driver is the changing technology landscape. Over this time period, IBMs standing as a leader in tech has been eroded by competition. Over this time period, net income is up only $1.2BN, from $6.5BN to $7.7BN, which is a 1% CAGR.
With its changing position, investors no longer valued the company as an exciting leader. At the end of 2003, IBM was trading at 24.5x LTM earnings. By the end of Q3’19, it is trading at 15.5x LTM earnings. That de-rating of 10x had a significant impact on its stock performance.
Secondly, I think the company made some really poor investments. What investments you ask? Buying its own stock in large amounts. Admittedly, without these buybacks, the price performance of IBM would have been abysmal.
I pulled the company’s cash flow statement over these ~16 years and analyzed what it did with cash. While we have hindsight bias, the company deployed too much into its own stock instead of trying to strengthen its position in a changing climate. You could even argue that they should have done more acquisitions. Excluding the recent RedHat acquisition, which was $33BN, the company did not actually spend that much on acquisitions over this time frame.
Outside of acquisitions, you could even argue that they should have just distributed cash to shareholders with special dividends. Again in hindsight, that would have allowed investors to purchase other businesses that are allocating capital for growth.
Let me be clear, I am a huge fan of buybacks and not trying to beat the drum that politicians like to use (buybacks aren’t an efficient use of resources and stifle growth etc.). It is a return of capital though. One might say its a return of capital to selling shareholders (because the buybacks would create a new buyer in the market to lift the price) but I view it as a return to existing shareholders – my proportional share of each new sale increases.
One of my favorite companies is LyondellBasel (ticker LYB). While it is a cyclical, commodity chemical company operating near peak, they’re capital allocation decisions make sense. First, invest in their equipment for safety. Second, ensure that they are well prepared in an evolving landscape. Third, return cash to shareholders while managing a prudent balance sheet. They have bought back 10% of their outstanding shares each year for the past few years.
In this case, however, it seems like IBM bought back shares just to buyback shares.
It makes some sense. If investments are competing for my next dollar, it is true that treasuries at 3% look a lot better than <1%.
I have already argued that I am bearish on the notion that interest rates will rise much further from here.
I have based that on (i) real long-term interest rates are lower than people probably think, but are skewed by the high rates of 80s & 90s, (ii) demographic headwinds (baby boomers aging will roll into lower risk securities), (iii) technological improvements are a large deflationary headwind, which will keep rates in check, and (iv) global interest rates remain very low compared to the US and the US is the best house in a bad neighborhood, which will drive increased demand for US$. A strengthening dollar also puts downward pressure on inflation.
Given rates moved up quickly from their lows to ~3.2%, I wanted to show interest rates affect on stocks using a hypothetical company.
I have made these numbers up, but used average S&P EBITDA and EBIT margins for my starting assumptions, assumed a 25% incremental margin, and a 27% tax rate. I also assumed capex = depreciation as this example is a mature business and growing only at about GDP (3%).
Here’s a summary below of where it is currently trading and model:
As shown, the company is currently trading around 12x LTM EBITDA (average S&P company trades for 12.5x LTM). Let’s see if this particularly equity looks cheap based on a DCF. I use both the terminal multiple method and the perpetual growth method below.
As you can see, the implied prices I get are right around the stock’s price today meaning the stock is trading for fair value. What’s the downside if interest rates go up 1%?
Well first, we need to access the impact on our weighted average cost of capital, or WACC. I assume the risk free rate is 3%, as it is today, the beta of this stock is 1.1, and the equity risk premium is ~5%, in-line with long-term history. I also assume the cost of debt is ~5.5%. It is important to remember that many company’s have fixed and floating rate debt.
As such, a 1% increase in the 10 year won’t actually impact a company with fixed rate debt until they need to reprice it. But for conservatism, I assume it is a direct increase in their cost of debt. Bottom line: I increase the WACC by 1%.
So how does this translate into our company? Well, as seen below in the bottom right box, a 1% increase in the discount rate would have a ~5% impact on our stock value, all things being equal.
Bottom line: Interest rates really have not moved to 4% and so I am skeptical of the 10% correction in stocks today and the increase in rates thus far actually impairing their prospects. Rising rates simply do not affect stocks this much.
I think humans are inherently story tellers and perhaps a good story provides some comfort. And that’s why anecdotal evidence creeps into our investment processes.
To me, though, it is no different than someone saying, “well my Dad smoked a pack of cigarettes a day and he lived to be 90!” Ok, so is that actually good evidence for me to smoke? Or should I trust the troves of actual, scientific evidence that says I should not smoke? (yes, I know I just wrote an article about “sin” stock out-performance)
Equally, when I hear a stock pitch or reason for investment, I hate to hear anecdotal evidence as a real justification. Here are some examples:
Media: I just cut the cord and hear all my friends are too. Cable companies like Comcast are going to face pressure
Transportation: I hear millennials are all about traveling compared to buying new products. I am buying airline stocks that will benefit from this.
Healthcare: My grandma needs a lot of medical attention. As the baby boomer wave hits retirement, the amount spent on healthcare is undeniable going up.
Retail: I only shop at Amazon now. All other retail / distribution is essentially un-investable.
New Technology: I read an article on how this [new technology] was able to do [something in a novel way]. There’s going to be a paradigm shift in the way we do things.
I think this type of investing is popular for a few reasons. For one, it is easy. You can just identify something you know and think of a company that will benefit from a trend. Second, Peter Lynch often wrote in his books that his children would talk about something they liked, he bought the stock, and it ended up being a 5-bagger or something.
I do think it is extremely important to be aware of trends, but this sort of investing has led to a lot of trouble. You also have to know “what is priced in”. For example, look at the return of Comcast since cord cutting really starting about 10 years ago — it is up 300%+ compared to the S&P return of ~170%.
Sure Netflix is up more, but do you think many people analyzed whether or not growth in other Comcast businesses would offset the traditional cable model? Or that this was a lower margin business so therefore it didn’t impact earnings as much as one would expect? Also think about how much people complain about Comcast… yet it still prints a lot of money. That is a testament to its business model!
On the flip side of that negative outlook, look at something in the technology sector like 3D printing. It used to be all the rage where people would discuss how the industry would change the world after they saw it in action. However, that would have been a disastrous long-term investment decision, as shown below:
These types of situations often allow a contrarian investor to profit. All asset prices reflect people’s expectations of future growth. By analyzing what investor expectations are compared to the price today, we can see whether an investment makes sense and is particularly undervalues. That’s often why in my model I run a “worst case” scenario for industries in which people believe are in secular decline as well as a “what do you need to believe” in the case of booming, hot technology stocks.
I like to invest in stocks where the expectations are really low. I’m critical of using GAAP net income and the P/E ratio for valuing a business (I prefer FCF), but for simplicity, let’s look at this example.
If you value a business on 1) current steady state part of the business and 2) the future growth of the business. For number 1, we should assign a multiple equal to the cost of equity. If that cost is 10%, that is a 10x multiple. If I buy the business for 10x and those earnings are sustainable, then any future earnings are complete upside for me. If I can pay a low multiple then for a company that has a history of value creation, then I can get the business for value + the upside for free.
I think I should also mention one other thing: a secular declining business can last a lot longer than people think, but it has to have the right capital structure.
For example, the yellow pages are still around! And the business actually throws off a lot of cash because the managers don’t need to reinvest in the business. However, YP has also been overlevered in the past, which has led to cases of bankruptcy. If someone had acquired the business for cheap, ran it with conservative leverage, then it might have been an attractive equity return.