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Dorsey: Cash Returns Look Compelling

Pat Dorsey, CFA

Pat Dorsey: Hi. I'm Pat Dorsey, director of equity research at Morningstar.

Let's talk about yields. They are fairly low right now, which is causing a lot of people some heartache when they try and get some income from their investments.

Right now the 10-year Treasury is at about 2.8%. Add another percentage point on that, you've got investment grade bonds in the high 3% range, 3.7%, 3.8% take a pick--return levels that are not terribly attractive, if you are an income-seeking investor.

But, of course, we need to always think of investing as "where are the best opportunities?" when you allocate capital; let's look at apples-to-apples and then put the capital where it has the highest prospective return. And so to put things on an apples-to-apples footing, I think it's often useful to treat stocks like bonds and look at their yields and not just the dividend yield. What I want to do is use something called the "cash return," which is basically the free cash flow of a business--that is, the cash that it spits off after accounting for capital expenditure as a percentage of enterprise value. And enterprise value is simply the market cap of the company plus its debt load less any cash.

Enterprise value basically represents what it would cost you to buy the whole business lock, stock and barrel. And so then, cash return, or free cash flow divided by enterprise value, is basically the return you would get if you bought the entire business lock, stock and barrel, and then just were able to take that free cash flow stream as a return to you for that investment that you just made.

Now, of course, free cash flow, cash return, is not the same as a dividend yield. The free cash that a business produces can be used to buy back shares. It can be used to reinvest internally in projects. It can, of course, be used to make value-destroying acquisitions, which is something CEOs love to do, sadly enough.

However, it does put equities on an equal footing with bonds, and I think it's fascinating to note. I did a screen recently; I looked at every domestic company trading in the U.S. with a market cap of over $5 billion--I took out financial companies because free cash flow is calculated a little bit differently for them, so you needed to exclude them from the analysis. And then said, which companies have cash returns better than Treasuries? Better than investment grade bonds? And I will tell what I found:

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There are 60 companies with market caps over $5 billion right now with cash returns over 10%. And there are further 80 companies, again, good sized businesses, market caps over $5 billion, with cash returns between 7% and 10%. So, that means you've got 140 businesses you could buy that have cash returns of 7% or better--well, well in excess of what investment-grade bonds are offering right now.

Those are pretty good rates of return. Those are the rates of return that account for a little bit of error, you know, value destroying actions by management. And if you are getting 10% return on the equity, that's pretty darn attractive I would say from an equity investor's perspective. Those 140 businesses that have cash returns over 7%, about half of them we think are trading at 15% or more below fair value, so we think they are good deals as well.

And I think what this analysis shows is just that, again, putting equities on an equal footing, treating equities just like you would look at bonds, looking at both on a yield basis, you can see some reasonably attractive opportunities out there in equities.

Then it also points out, I think, in terms of stocks versus bonds, some very odd things that we are seeing right now, which is companies with dividend yields higher than their 10-year bonds--very, very odd. For example, right now, Johnson & Johnson, which has a dividend yield of about 3.6%, has 10-year bonds yielding about 2.9%. And, of course, that dividend is going to rise over time, whereas that bond payment is fixed. It's not going up. That's why it's called fixed income.

I looked at a number of companies in our database, and I found about good 20-25 companies, where the dividend rate, the dividend yield, is half a percentage point or more higher than their 10-year bonds. That's a very unusual circumstance. It's a very odd thing for a company's dividend yield to be that much higher than the rate being paid on its bonds--that's 10-year bonds, which are little more equity like because they have a long life to them.

It's a very unusual circumstance, and it's also unusual in the context of something I have talked about in past videos: very, very strong inflows into bond funds and very, very strong outflows from equity funds. It makes one think that perhaps the pendulum is swinging too far in one direction. Maybe so, maybe not, but the data are certainly leading me to think at least that it is.

I'm Pat Dorsey, and thanks for watching.