Do You Own a Company or a Stock?
Our interest is in finding firms with sustainable dividends. Most investors wish to live off of their portfolios, not worry about them. Thus, our task is to own companies, not securities, for the long term.
As Warren Buffet has bemoaned, no matter what he has to say in his annual reports, the press is always going to ask what he thinks will happen in the economy and the markets this year. We have a natural talent for expecting much of forecasting. We have a talent for ignoring all the times forecasts are wrong and selectively recalling those few times when they may be right. A stopped watch is right twice a day.
One of the basic models used today by virtually all investment advisors, writers, technicians and academicians is ‘next year’s earnings forecast’. Forecasting is like betting. If you are the house, you win enough to make a good living. You do not have to be right. You just have to have enough punters. Investment banks know this. Mr. Buffet knows this. He is not the house. He is the one who chooses not to bet. He is the consummate follower of Benjamin Graham.
There are no consistently accurate forecasts. There is no way to know, with any degree of certainty, what will happen tomorrow, next week or next year. To forecast means to take an educated guess about a partial set of data to arrive at certain conclusions. It is inductive reasoning gone wild. It can be correct. It usually isn’t. You cannot get a market forecast in GrahamandDoddsville. Projecting future earnings and making investment decisions upon those projections is based upon more uncertainties than certainties – despite what most CFAs will tell you.
We are more interested in free cash flow. Free cash flow is significantly different from earnings, whether net or gross. Gross earnings are before expenses. They are a direct result of the sales of the company’s goods or services to an audience of buyers. Earnings reflect upon the success of the design, production, marketing, management and direction offered by the workers, managers and stakeholders. Net earnings reflect the diminution of gross earnings by overhead: employees, offices, equipment, taxes, etc. Net earnings are the general statement of the financial and management capabilities of the firm.
Free cash flow is the amount of capital available for distribution as cash to the owners of the company – the shareholders. It is arrived at by further reducing net income by charges for interest, depreciation, amortization, working capital and capex. If any of these items are excessive, it will show in the FCF. Thus, we look for firms with debt to equity of less than 80%. This leads us naturally to firms with FCF.
In fair and full disclosure, FCF can be manipulated to some degree. Maintenance capex does not have to broken out from actual capex under GAAP. Capex can be irregular if made for significant but infrequent capital expenditures, perhaps decadal capital projects. The decision to incur such excess capital costs can be disruptive. It can also be viewed as a costly means to an end result. Footnotes to balance sheets will tell if maintenance capex is a break out item. Excessive capex is obvious for all to see – it probably reduces or removes the dividend distribution. Such glaring examples are quickly observed.
Thus, free cash flow (NYSE:FCF) is one of the most restrictive ways to view the success of a company. What does it have left over after covering all overhead, accounting events and future capital needs? This is a truer measure of success. It has nothing to do with projections of future sales of widgets or wombats. It is one of the core tenants of value investing
Firms with FCF can either use the capital for business development (Capex), share buyback, compensation or dividends.
Capex is often the first and best use of capital. Senior management should know how to grow the business.
Many feel that share buybacks result in growth for the share price. We do not agree. It is usually a series of stock purchases at above market prices.
Using excess capital for compensation is a losing game – just ask the folks in Washington.
Of course, they can do nothing with the funds, too. Observe: Barrons recently listed twenty firms with the highest FCF to market cap. Many of these firms pay little or no dividend.
We look for those firms which have significant FCF and use some portion of it as a dividend. That makes good business sense. Shareholders enjoy the fruits of their ‘capital labor’.
When you review a company’s FCF and find it welcoming, it is easier to own the firm. Your client (and you) can sleep well at night and not worry, excessively, about the company’s prospects. The value in the company is real. It is real in the present. It is measurable – by the dividend just paid. Your client cashes the dividend check.
The markets like dividend checks. There are not fungible. They are not accounting gimmicks. They cannot be hidden from view by an enterprising executive. They are an actual measure of the company’s worth. Dividend checks do not come, usually, from exciting companies.
Dividends, once paid, tend to continue to be paid each quarter. Senior management becomes very reluctant to stop the flow of shared wealth to the shareholders. Look at a firm like CenturyTel. It has paid dividends since 1974 - thirty six years. That demonstrates nearly everything you want to see in a company: a good product, well maintained market share, excellent service, strong employee/ management/ stakeholder relationships, significant debt and capital controls and consistency of behavior throughout a variety of markets and phases of the economy.
As a result, the firm’s share price does not radically gyrate in either direction. It dances to it’s our drummer. CTL is trading at essentially the same price it has for more than a decade, while paying dividends at a slowly increasing pace. It is a classic example of the value stock – boring.
When exogenous events occur, such as the 2008-09 melt down, value stocks get hit. When a storm hits, all ships are in danger, even those in safe harbor. When the storm subsides, the value merchant remains afloat because it is more watertight. It’s ‘moat’ is wider.
Left to its own devices, a value stock’s price will more closely reflect the actual worth of the company. An investment in a company should be based upon the worth of that firm. Its worth is best understood as the sum total of its products, services, employees and good will.
When you invest, does it make sense to own a company or a stock?
 Some view the constant expenditure of capital for exploration and discovery by the integrated oil firms to be a costly form of capex. The opinion may be that returns were below the cost of capital.
 WWE may be an exception to this statement. It has very little debt, significant FCF and has paid a sizeable dividend for eight of its eleven years as a publicly traded firm. It is also very exciting, for those who like this sort of thing! Oh, its FCF continues to grow beyond expectations.