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Equity Valuation From A Bond Perspective: 5 Picks With Attractive FCF Yields

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Includes: CACC, CFRHF, CFRUY, CLIUF, EWD, EWU, NTNTY, PANDY, PLSQF, PNDZF, SPY, TIF
by: Urbem Capital
Summary

Admittedly, stocks are widely expensive in absolute terms.

However, investors should also beware that stocks compete with other investment alternatives.

The ultra-low bond yields should be telling a different story regarding equity valuations.

Check out the 5 undervalued picks with attractive FCF yields priced in a decent margin of safety.

Source: cnn.com.

Overview

Are stocks expensive? After the longest bull market in history, this question is inevitably raised among many investors. From an overall market perspective, the Warren Buffett Indicator is telling us that stocks are overvalued in many parts of the world (especially the developed one). For example, according to GuruFocus below, the Indicator is above 100% in major markets like the US (SPY), the UK (EWU), and Sweden (EWD).

Source: GuruFocus; data as of 9/14/2019.

However, the prevailing "race to zero" among central banks around the globe has been pressuring government bond yields. As the old saying goes, "interest rates act like gravity on equity valuations." The reason is simple: stock investors measure prospective returns against the so-called risk-free rate.

To be specific, they would, on the top of the government bond yield, demand the equity risk premium, which is determined based on the quality of the business (e.g., economic moat, financial strength, earnings quality) and growth prospect. For example, a high-quality business generating 5% earnings or free cash flow on the cost of stock purchase with a 5-10% CAGR should look appealing compared with a 10-year government bond yielding less than 2%. After all, the government would not raise its coupon payments, unlike businesses.

With this in mind, we could learn from the chart below that the S&P 500 is getting cheaper over the past few decades in relation to bond yields, which has been steadily trending down.

Source: GuruFocus; data as of 9/14/2019.

The current market P/E of over 22x implies an earnings yield of a bit less than 5%. It may not appear "rich" in light of the 10-year risk-free rate of 1.9% to those who believe that the low yield is the new norm.

Especially for high-quality stocks, a risk premium of 3% typically makes sense in my opinion. However, to demand a greater margin of safety in today's extraordinary low-rate environment, conservative investors could go with 5%.

Below are some picks of stocks with strong fundamentals trading at attractive FCF yields at the moment. Many of them have a decent prospect to grow their FCF even further.

Credit Acceptance (CACC)

Michigan-based Credit Acceptance Corporation offers financing programs that enable automobile dealers to sell vehicles to consumers, regardless of their credit history. The business model here is quite simple to understand - the company gets capital through various debt financings (hopefully cheaply) and, in turn, lends it out at higher prices in hopes of making economic profits after all fees, borrowing costs, operating expenses, delinquencies, and defaults.

The stock is currently yielding 8.2% free cash flow, compared to the 1.9% 10-year US treasury yield (see below).

Source: GuruFocus; data as of 9/15/2019.

Source: worldgovernmentbonds.com; data as of 9/14/2019.

The prudent capital allocation and strategic focus on the subprime auto loan build the economic moat for Credit Acceptance. The business, as you can see below, consistently generated high returns on tangible assets (mostly above 10%) over the past decade.

Source: GuruFocus; data as of 9/15/2019.

At the same time, the company delivered a high-teens CAGR in free cash flow per share (see below), mainly driven by the expansion of the active dealer network. Although Credit Acceptance has been encountering increasing competition over the years, it is worth mentioning that we might already be in the late-cycle phase of the economic boom. The company, with its expertise in the subprime auto loan, usually weathers recessions much better than its peers, whose businesses could suffer, lose market shares and even be wiped out during tough times.

Source: GuruFocus; data as of 9/15/2019.

NetEnt (OTCPK:NTNTY)

Sweden-based NetEnt AB is a leading digital entertainment company, providing premium gaming solutions to the world's most successful online casino operators. Running on a partnership model, the company is responsible for operations and monitoring of gaming transactions through hosting and gaming operators pay royalties to the company based on a percentage of the game win (i.e., player bets minus player wins) generated.

The stock is currently yielding 7.8% free cash flow, compared to the negative 10-year yield of the Swedish government bond (see below).

Source: GuruFocus; data as of 9/15/2019.

Source: worldgovernmentbonds.com; data as of 9/14/2019.

NetEnt benefits from the high barrier of entry (thanks to the ongoing re-regulation) and superior product quality to sustain its leading position. As described below, the business generates over 40% returns on tangible assets every year over the past decade.

Source: GuruFocus; data as of 9/15/2019.

In the meantime, NetEnt increased its annual free cash flow by almost 6x (see below), mainly driven by product launch and geographic expansion. The global online gambling market is forecasted to register a CAGR of 9.7% from 2018 through 2023. The company has an estimated global market share of 17 percent, and 28 percent in Europe. Landed casino still dominate the gambling space (95% landed vs. only 5% online). NetEnt should have plenty of rooms to grow with the market as well as alongside the market.

Source: GuruFocus; data as of 9/15/2019.

Pandora A/S (OTCPK:PANDY) (OTCPK:PNDZF)

Denmark-based Pandora A/S is an international jewelry manufacturer and retailer best known for its customizable charm bracelets, designer rings, and necklaces. With the core values of affordable luxury, contemporary design, and personal storytelling, the company has a production site in Thailand and markets its products in more than 100 countries on six continents.

The stock is currently traded at 5.2x trailing free cash flow, indicating an almost 20% FCF yield (see below) compared with a negative 10-year yield on Danish government bonds. The overselling of the stock was mainly due to the concerns on the like-for-like growth, fading consumer interest in charms and bracelets, and an overall secular downtrend in offline retail sales at shopping centers. However, the management has come up with its turnaround plan - Program NOW, which comprehensively touches upon several aspects of the business, including the brand relaunch, scale-back on network expansion, cost reduction, and inventory improvement.

Source: GuruFocus; data as of 9/15/2019.

Source: worldgovernmentbonds.com; data as of 9/14/2019.

Largely through its brand, scale advantage, and low-cost production, Pandora A/S built its economic moat, which fends off competition from strong peers like Tiffany & Co. (TIF) and Cartier (OTCPK:CFRHF) (OTCPK:CFRUY), and hence, enables the company to earn consistently superior returns on tangible assets (see below).

Source: GuruFocus; data as of 9/15/2019.

The annual free cash flow at Pandora has increased by roughly 15x over the past decade (see below). Despite the short-term uncertainties around the business, I would expect the long-term prospect of Pandora to be positive, assuming that the management put the right growth strategy in place. Growing SHEconomy, international expansion, and digitization are the three secular-growth opportunities facing the company.

Source: GuruFocus; data as of 9/15/2019.

Plus500 (OTC:PLSQF)

Israel-based Plus500 Ltd. is an international financial firm providing online trading services in contracts for difference, across more than 2,000 securities and multiple asset classes.

The current free cash flow yield of the share is 16.4%, while the yield on the 10-year Israel government bond is only a little over 1% (see below).

Source: GuruFocus; data as of 9/15/2019.

Source: worldgovernmentbonds.com; data as of 9/14/2019.

As described below, Plus500 consistently earned superior returns on tangible assets (above 60% every year) over the past few years, thanks to the high barrier of entry (resulting from increasing regulation) in the CFD retail trading space as well as its leading position in trading technology with omnichannel digitizations.

Source: GuruFocus; data as of 9/15/2019.

At the same time, Plus500 registered an astonishing CAGR of over 50% in free cash flow (see below). Moving forward, major growth drivers are market penetration and geographic expansion. The business model is quite scalable, as long as higher user lifetime value (driven by average annual revenue per user and user churn) is earned than the user acquisition cost is incurred.

Source: GuruFocus; data as of 9/15/2019.

City of London Investment Group (OTCPK:CLIUF)

UK-based City of London Investment Group positions itself as the leading EM CEF (emerging markets closed-end funds) asset manager with a concentration on institutional clients and a track record of outperformance over multiple market cycles already. In recent years, the group has expanded its range to include Developed, Frontier and Opportunistic Value closed-end fund strategies.

As you can see below, the share currently yields over 11% in terms of free cash flow, compared to the 0.76% 10-year yield of UK government bonds.

Source: GuruFocus; data as of 9/15/2019.

Source: worldgovernmentbonds.com; data as of 9/14/2019.

City of London Investment Group has a leading reputation in CEF investing with a decades-long track record of outperforming the benchmark. This is hard to replicate by CLIG's competitors. Additionally, the niche market of CEF investing may not be that big for some bigger traditional asset managers to concentrate their resources on. These sustainable competitive edges are reasons why the company earned superior returns on tangible assets (always above 25%) over the past 10 years, as displayed below.

Source: GuruFocus; data as of 9/15/2019.

Meanwhile, the annual free cash flow increased mildly (see below). For the long run, the growth will be fueled by expansions in terms of geographic locations as well as products. The company has been increasing range of investment markets to be covered, building upon its core expertise in CEFs, while the expansion of the client base in the US, Europe, Asia, and the Middle East will continue.

Source: GuruFocus; data as of 9/15/2019.

Summary

The ultra-low bond yields around the world are telling a different story regarding equity valuations, according to which, many stocks may be undervalued even with a 20x P/FCF. Of course, investors may want to assume a higher equity risk premium for a greater margin of safety. The above 5 picks are some good examples of undervalued stocks from a relative yield perspective.

What is your favorite high-FCF-yield stock? Feel free to comment below.

Disclosure: I am/we are long CACC, NTNTY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please be aware that mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.