By Serkan Unal
Empirical research shows that stocks of companies with high free cash flow yields have historically outperformed the stocks of companies with low cash flow yields and the broader market. According to Fred Alger Management's citing of Empirical Research Partners' analysis, in the 50-year period through May 2011, stocks of companies with high free cash flow yields generated an excess return of 6.6% per year relative to the broader market.
Research from asset manager Manning and Napier supports the idea that, over the long term, stocks with the highest free cash flow yields tend to outperform their counterparts with lower free cash flow yields and the broader market. Between 1990 and 2011, "the highest quartile of free cash flow yielding companies (rebalanced annually) has generated total returns greater than any other quartile and the equal weighted holdings of the Russell 1000 Index." Furthermore, a pairing of securities with the highest free cash flow yields and highest dividend yields has produced the "highest level of total return when compared to either dividend yield or free cash flow yield alone, or the equal weighted holdings of the Russell 1000 Index."
While past performance is no guarantee of future results, currently, there are several stocks with dividend yields above the 2.0% yield of the 10-Year Treasury bond, low dividend payout ratios suggesting room for further dividend increases, and free cash flow yields above 6.7% (price-to-free-cash-flow at or below 15). The seven stocks presented below also have past and forward long-term EPS CAGR of at least 5%, return on equity of at least 15%, and trailing and forward P/Es at or below 15.0x. While some of the featured stocks, such as General Dynamics Corp. (NYSE:GD), Macy's Inc. (NYSE:M), and Western Union (NYSE:WU), are experiencing near-term challenges, they all have competitively high free cash flow yields and the rates of EPS growth exceeding the rate of U.S. economic growth. Value-oriented dividend growth investors should pay closer attention to these stocks due to the stocks' low payout ratios and the record of large dividend increases and share buybacks.
AFLAC, Inc. (NYSE:AFL), a life and supplemental insurance provider, has a free cash flow yield of 57%. The company generated some $14.3 billion or $30.4 per share in free cash flow on a trailing-twelve-month basis. The company's free cash flow has been rising at an average rate of about 30% per year over the past five years. Aflac is an S&P Dividend Aristocrat with 30 years of consecutive annual dividend increases. The insurer has a strong balance sheet and is well capitalized. According to Barron's, Citigroup recently initiated coverage on life insurers, making Aflac its top industry pick and saying it sees "several positive near-term catalysts (for Aflac), including the resumption of share buybacks, improved investment yields, and the stabilization of Japan margins." The bank believes Aflac's "earnings growth has reached an inflection point and should get back to the 8-10% range over the next few years." Analysts see Aflac's EPS expanding at a robust long-term CAGR of 10.2%. Based on the last 13-F filing, Citadel Investment Group's Ken Griffin was especially bullish about Aflac in the third quarter of 2012.
Amgen Inc. (NASDAQ:AMGN), a biotechnology medicines company, has a high free cash flow yield of 7.6%. The company generates consistently high free cash flow, and, although free cash flow has been volatile from year to year, it is currently high at $4.8 billion or $6.32 per share. In addition to the cash-rich and solid balance sheet, the company's advantage is its robust and diversified pipeline of 43 products in all phases of development. Analysts forecast the company's long-term EPS CAGR at 11.0%. The stock is valued at 11.9x forward earnings, a 25% premium on the biotech industry, but cheaper than peers Johnson & Johnson (NYSE:JNJ) and Novartis AG (NYSE:NVS). Based on the last-available 13-F filings, the stock was popular with AQR Capital Management's Cliff Asness, while David Cohen (Iridian Asset Management) and Ric Dillon scaled down their positions in the third quarter of 2012.
Ford Motor Co. (NYSE:F), the second largest automaker by market share in the U.S., has a free cash flow yield of 7.6%. The company generated $3.9 billion or $1.04 per share in free cash flow on a trailing-twelve-month basis. Still, free cash flow will face some headwinds in the near term, due to rising capital spending (to $6 billion by mid-decade) and pension contributions. The company is upbeat about future growth, expecting global sales to rise by 50% to 8 million vehicles by 2015 on potential growth in China and India. The prediction was made in 2011. Ford is trading at 9.4x forward earnings, slightly above General Motors Co.'s (NYSE:GM) multiple of 8.9x but well below Toyota Motors' (NYSE:TM) multiple of 16.1x. Ken Heebner of Capital Growth Management established a new position in Ford in the third quarter of 2012.
General Dynamics Corp. , an aerospace and defense company, has a free cash flow yield of 10.9%. The company generates large free cash flows each year. On a trailing-twelve-month basis, its free cash flow is $2.7 billion or $7.74 per share. The company recently reported a $2.1 billion fourth-quarter loss, a result of a large write-down that is attributed to ill-advised acquisitions. Its revenue decline in the past quarter was mainly driven by the losses from its European operations. Due to weak defense spending, GD forecast a 2013 profit of between $6.60 and $6.70 per share, below the consensus analysts' estimate of $7.32 a share. This has resulted in the trimming-down of analyst estimates, which has cut the long-term EPS CAGR forecast to 5.1% from 6.4% a month earlier. The stock is trading at 10.4x, about on par with the defense industry. The stock is owned by Warren Buffett (see Buffett's holdings here).
Macy's Inc. , a department and online store retailer, has a free cash flow yield of 7.6%. The company generated $1.17 billion or $2.96 per share in free cash flow in the trailing twelve months. Macy's has implemented a strategic overhaul in the past few years, boosting its performance above expectations. Despite slow employment and income growth, which have weighed on consumer sentiment, consumer spending remains resilient. Macy's same-store sales were up 4.1% in December 2012, with online sales growing 51.7% year-over-year. However, the company lowered its estimate of fourth-quarter sales and EPS. Still, with an economic recovery ahead, analysts expect the company to boost its EPS at a CAGR of 11.2% for the next five years. The stock is trading at 10.7x forward earnings, a major discount relative to broadline retailers as a group. Maverick Capital's Lee Ainslie initiated a major new position in Macy's in the third quarter of 2012.
Seagate Technology PLC (NASDAQ:STX), a hard disc drives manufacturer, has a free cash flow yield of 22.2%. Its total free cash flow on a trailing-twelve-month basis is $3.1 billion or $8.3 per share. While the company's business will likely suffer in the long-term due to a secular decline in the PC market, Seagate Technology upped its revenue estimate for its second fiscal quarter from an earlier estimate of $3.5 billion to at least $3.6 billion, a 12.5% year-over-year increase. However, its profit margins will be at a lower end of its earlier guidance. Based on the earnings report of its rival Western Digital (NASDAQ:WDC), the higher-margin enterprise sector is picking up some of the slack from declining PC sales, driving shipments and sales higher. Seagate Technology has raised dividends twice in the past four quarters and remains committed to increasing shareholder value through dividend distributions and stock buybacks equal to 70% of operating cash flow. The stock is trading at only 7.2x forward earnings, still higher than rival Western Digital's 6.2x. Billionaire David Einhorn reduced his large position in STX in the third quarter of 2012.
The Western Union Co. , a money-transfer company, has a free cash flow yield of 8.8%. The company's free cash flow on a trailing-twelve-month basis was $708 million or $1.17 per share. The company's stock dived in late October as the company posted weak revenue growth and guidance. At the end of October, the company has said "2013 constant currency revenues may decline slightly and GAAP operating income may decline 10% to 15% from 2012 levels, if economic conditions remain soft and all actions are implemented as contemplated." As a result, analysts have revised downward their EPS estimates. Still, currently, they are seeing WU's EPS CAGR at a robust 9.0% for the next five years. It should also be noted that, at least in the near term, stock buybacks may buttress WU's EPS growth, as $750 million is approved for share buybacks through the end of 2013. The company trades at 9.3x forward earnings, below MoneyGram International's (NASDAQ:MGI) 12.5x. According to the last-available 13-F filings, in the third quarter of 2012, the stock was popular with Chieftain Capital's John Shapiro.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Dividendinvestr is a team of analysts. This article was written by Serkan Unal, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.