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Wednesday, July 10, 2013 - 10:00

The Crucial Advice From Buffett You're Probably Ignoring

Wednesday, July 10, 2013 - 10:00am

As we head into earnings season, investors have ample reason for both optimism and caution.

The U.S. economy appears to be getting healthier, as seen by the recent monthly employment report. Yet stocks, after a stunning four-year rebound, appear to already anticipate a great deal of solid economic growth yet to come.

Will the economy come through? It's too soon to know. We are not yet at a level of self-sustaining growth that leads economists to declare with certainty that 2014 and 2015 will represent steady and strong growth.

That's why I continue to suggest a focus on stocks with defensive characteristics. They are still capable of solid upside if the economy expands at a healthy pace. Yet they have valuations in place that will help them hold their ground if the economy (and stock market) stumbles in the months ahead.

A key measure of safety is free cash flow yield, which is a company's free cash flow (operating cash flow minus capital spending), divided by a company's market value. Many companies in the S&P 400 (mid-caps), S&P 500 (large caps) and S&P 600 (small caps) sport free cash flow yields in the 3% to 6% range. Yet fewer than 100 out of these 1,500 sport free cash flow yields in excess of 10%.

While on the subject of yield, investors like to see a hefty amount of that free cash flow paid back to shareholders in the form of dividends. I screen for stocks that sport both double-digit free cash flow yields along with dividend yields above 4%. (I recently discussed the importance of that 4% threshold.)

These aren't the kinds of stocks that are bound to outperform the pack in a surging bull market, but they offer a solid combination of decent upside, good yields and, most importantly, downside protection. (Those solid yields would rise higher if the stock price falls, attracting a new round of yield-seeking buyers.)

Many of these stocks are electric utilities and telecom service providers, which are expected to check off these boxes in terms of the paired yields. Here's a look at the eight stocks that sport solid free cash flow yields and dividend yields.

The first thing to check for is the difference between these two figures: The free cash flow yield should always be higher. If not, the free cash flow is insufficient to support the current dividend.

Second, you need to assess the long-term sustainability of the business model. For example, Pitney Bowes (NYSE: PBI) and R.R. Donnelly (Nasdaq: RRD) both live in a paper-based world at a time when the world is going paperless.

A pair of stocks in this group holds appeal. Calamos Asset Management (Nasdaq: CLMS) is remarkably inexpensive in the context of its free cash flow, which I discussed a few months ago.

Investors may also want to check out automobile insurer Safety Insurance (Nasdaq: SAFT), which has managed risk quite well, generating positive free cash flow for at least the past 10 years. Moreover, this insurer has hiked its dividend at least 10% in seven of the past eight years, boosting the payout from 44 cents a share to $2.40.

Risks to Consider: Rising bond yields are taking some of the luster off dividend-paying stocks, but any pullback in the share prices of these dividend payers could represent great entry points, as long as the rate rebound in fixed income remains manageable.

Action to Take --> An ever-rising market has left investors with few certifiable bargains. If you think it's time to pivot away from growth and toward value, then these solid yielders hold great appeal.

P.S. -- Current yields averaging 7.2%... gains of more than 127%... and 43% safer returns than traditional investing. Amy Calistri's Daily Paycheck advisory is delivering all of these things and more. Right now, 91% of her picks are winners, and she's collecting more than $1,400 per month in dividend checks. Click here to see how she's doing it and how you can join her today.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.