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Three Wide-Moat Picks with Compelling Free Cash Flow Yields

Jason Stipp

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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Stipp: So, this is money potentially that the business could put back to work, and we're seeing attractive free cash flow yields among some stocks. But as you were saying, it still pays to be selective because you want a company that probably will do the right thing with this money, either in reinvesting it or in paying it out.

You have some ideas for some really attractive companies with free cash flow yields. The first one is in the defense industry. Tell us a little bit about that pick, what it's yielding, and why you think it's attractive?

Larson: General Dynamics, this is a wide-moat defense contractor. They have a wide moat because they are the sole provider of a large number of defense items such as nuclear submarines, certain tanks, so on and so forth. The free cash flow yield on this stock is just under 10% today. I think this is a very attractive price for a company that is, excuse the pun, very defensive, very little economic sensitivity.

Yes, there is concern about budget deficits and will we see a lower defense spending in the future. But I think that the market is pricing that in and then a whole lot more conservatism over and above what it already is. Our fair value estimate on General Dynamics is $78. The stock is in the low $60s. I think it's an attractive bargain.

Stipp: So certainly thinking of 10% and comparing it to what you might get on certain fixed income instruments, there's a vast difference there. What is a typical free cash flow yield? I mean, 10% obviously seems high, but where would you expect the stock to be under normal times?

Larson: I would say somewhere in the 4% to 5% range for a company that has, what you might call a normal growth rate. General Dynamics, as I mentioned, will have a lower than normal growth rate. But the sales that they do have, I think, are very steady. This is a company that has, for instance, a backlog that nearly represents two years worth of sales.

Stipp: So, certainly at a 10% rate, there's a lot of room for a few bumps in the road along the way and you're still getting paid pretty handsomely for that at that price?

Larson: You are absolutely right.

Stipp: Second one, Paul, is in the health-care space, also considered to be relatively defensive. Tell us a little bit about that.

Larson: Sure. Novartis, this is a health-care giant based out of Switzerland, and they are in all sorts of health-care arenas, whether its vaccines, pharmaceuticals, consumer products, devices. They basically cover the waterfront in health care.

This one has a free cash flow yield that's a little bit lower than some of the most attractive highest free cash flow yields. The free cash flow yield is only about 8% for this company.

But I think that this is still a very attractive price for this, given the very defensive business that they are in as well as the fact that they should have a fairly handsome growth rate going forward, somewhere in the mid- to high-single-digit range. Again, it has a wide moat, a healthy balance sheet. I think that it's a very attractive trade-off between potential return and the risk, which is quite low.

Stipp: Last one, Paul, is for investors who might be willing to take on a little bit more risk. The recent past has been a little rocky from a regulatory standpoint in the for-profit education industry. Tell us a little bit about that one.

Larson: Sure. Apollo Education, and you're absolutely right. The last couple of years have been very rocky for all the for-profit education companies. But it's funny. If you look at the financial statements of these firms, and you didn't pay attention to the headlines and you just had the financials, you would think that these are just phenomenal businesses with very high growth rates, high returns on capital, very profitable businesses. But again, it's been very rocky in the headlines and some concern about whether the government is going to crack down on these. But the price that's available on the market again takes those factors and magnifies it to too-large degree.

Apollo Education, the free cash flow yield here is just under 11% today, and that is for a company that has had a growth rate in excess of 20% the last couple of quarters and also has a sparkling balance sheet, a couple of dollars a share in net cash, and very high returns on capital.

Stipp: So with a potential growth rate like that, certainly some risk that you have to keep on the radar that you want to be aware of, but at that price, it just looks pretty compelling.

Larson: I think you hit the nail right on the head there.

Stipp: Well, Paul, thanks so much for talking a little bit about this very interesting data point and for these specific ideas.

Larson: Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.