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By Jason Stipp | 10-07-2010 11:57 AM

Three Wide-Moat Picks with Compelling Free Cash Flow Yields

With low yields on most fixed-income investments, these picks could offer an attractive alternative, says Morningstar's Paul Larson.

Jason Stipp: I'm Jason Stipp for Morningstar. As investors have continued to put money to work in bonds, yields on that investment class have been persistently and stubbornly low.

But for those who are willing to think about yield a bit more broadly, we see some interesting opportunities in the stock space.

Here with me to talk about what he has found is Morningstar's Paul Larson. He is editor of Morningstar StockInvestor and an equity strategist. Thanks for joining me, Paul.

Paul Larson: Thanks for having me again.

Stipp: So, a quick question. If you can give an overview of the yield environment out there, it's tough right now for a lot of investors. What are you seeing when you're looking at yields across the investment landscape?

Larson: Well, you're absolutely right, it is very tough. If you walk up to the bank and you buy a CD, you're getting next to nothing. Same thing in the money market accounts. If you're going to go out and buy long-dated Treasuries, on the long end of the curve, you're getting somewhere between 2.5% and 3.5% today. That is a very low yield, both relative to other investments, namely stocks, as well as relative to what they've yielded historically.

Stipp: So, when you're thinking about yield with bonds, you obviously get this coupon. You get a payment back when you buy a bond in some sort of tangible yield. But when you're looking at stocks, obviously some pay a dividend and that's also cash back to you. But there are other ways to think about a yield from a stock. Can you explain that a little bit?

Larson: Right. One of the ways I like to think about it is by looking at the company's free cash flow yield. What this is, is you take all the operating cash flow that the company is able to generate in a given period and you subtract out the company's capital expenditures, and what's left is the free cash flow. Then you take that number and you divide it by the current market capitalization and you get a free cash flow yield.

You're absolutely right that this free cash flow does not flow directly to our pockets as owners of the business. But this is cash available for the owners of the business, and the company managers can either choose to pay it out as a dividend. They can also buy back shares with this cash flow that they're generating, or they can choose to grow and expand the business, either by organically building or by acquiring another business.

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