As Amazon.com (Nasdaq: AMZN) ventures into a few new categories every year, it foots the bill by redeploying cash flow from other, more mature divisions.
At the other end of the spectrum, you have companies that are already quite mature. They have few growth initiatives to pursue, and much of their operating cash flow is converted right into free cash flow. Such stocks tend to be shunned by growth investors, but for the value crowd, they hold great appeal.
Their robust free cash flow can be used to pay down debt, boost the dividend or induce share buybacks -- the three pillars of what we call Total Yield.
I scanned all of the companies in the S&P 400 (mid-cap) and S&P 500, looking for companies that generate impressive levels of free cash flow. I then narrowed my search to only focus on stocks that trade at reasonable valuations in relation to that free cash flow. Of the 900 candidates, only 15 trade for less than 12 times free cash flow, and all sport free cash flow yields in excess of 9%.
To further narrow the group, I eliminated any firms that generated negative free cash flow in any of the past three years. That eliminated Archer Daniels Midland (NYSE: ADM), and Cliffs Natural Resources (NYSE: CLF) from contention.
What you have left are a group of slow-growing cash machines. Of course, slow growth is better than negative growth. They key is how such firms handle such top-line stress. Xerox's (NYSE: XRX) sales are expected to be roughly flat in 2014 and 2015. Analysts at Goldman Sachs will boost free cash flow per share from $1.19 this year, to $1.63 next year to $1.77 in 2016, thanks in part to cost cuts. The 14% free cash flow yield on those projected 2016 forecasts is simply too large to ignore for many value investors.
Yet even among this group of low-growth stocks, you'll find some impressive business models. Retailer Bed, Bath & Beyond (Nasdaq: BBBY), for example, dominates its niche, even as it has become a free cash flow powerhouse in recent years. But even good companies have bad years.
After a sharp plunge this week, shares of Bed, Bath & Beyond have fallen 30% from their 52-week high, as the retailer experiences soft demand and high expenses related to investments in growth initiatives. Still, Bed, Bath & Beyond remains remarkably profitable from a free cash flow perspective, and the current valuation is sure to start luring investors in search of deep value. The retailer is likely to generate tepid results over the next few quarters as well, but value investors tend to look past that.
Storage giant EMC (NYSE: EMC) appears on this list in large part because many mature tech stocks have now become deep value stocks. At a conference with analysts last month, EMC conceded that its core markets are slowing and the company will need to invest in new niches to maintain sales growth.
"EMC continues to aggressively invest in peripheral, faster-growth technologies like flash, software defined storage, cloud, etc., which should position it well for the next-generation data center," say analysts at Merrill Lynch. They think this tech firm can maintain $5 billion in annual free cash flow in coming years, equating to a 10% free cash flow yield. Part of that free cash flow is being applied to share buybacks and a modest dividend, though management likes to use cash for growth-inducing acquisitions as well.
On occasion, a stock will sport a high free cash flow yield because it is so deeply out of favor that the market value falls to very low levels. That was the setup in place for mining equipment firm Joy Global (NYSE: JOY), when I profiled it last September. Its shares are up roughly 20% since then (roughly keeping pace with the S&P 500) but are still 30% below levels seen back in 2011.
Investors are waiting to see an upturn in demand for Joy and its peers. Joy's sales are likely to bottom out this year at around $3.8 billion, before rebounding modestly in fiscal (October) 2015. Sales are expected to grow more robustly in subsequent years as the global construction economy rebounds. Equally important, Joy Global should produce prodigious free cash flow during that upturn. While shares are out of favor, Joy is buying back $300 million in stock this year.
Risks to Consider: These companies are generating solid free cash flow in a reasonably healthy economy. But many of them stumbled in 2008 and 2009, and would do so again if this economic upturn comes to an end.
Action to Take --> Free cash flow is a great measure to separate good stocks from bad stocks. Let's says you are examining two similar companies in terms of sales, sales growth and net income. If one of them has far superior free cash flow as well, it is the better buy.
Conversely, you may want to steer clear of any companies that appear unable to ever generate solid levels of free cash flow, especially if that company has been in existence for more than a decade. (Amazon.com, and its unique approach to growth, is an obvious exception.)