Free cash flow yields are high; it’s not hard to find a company trading 2 times the yield of the 30 Treasury year bond.
Simplistically, a free cash flow yield higher than the 30 year bond poses some interesting questions. According to James Glassman in Kiplinger’s Personal Finance, December 2010, “When a blue chip stock yields more than Treasury bond, that is a tremendous opportunity”. To us it’s not so simple.
For instance, a company with an abnormally high dividend yield implies there is something wrong with the company—that the market has properly priced in downside risk looming on the horizon. While a dividend yield and a free cash flow yield are drastically different—dividends can be financed free cash flow can’t—high free cash flow yields make us look twice.
We think there are 3 distinct yet related possibilities why such high yields exist in today’s market.
1. 1. Oncoming inflation—the market is pricing in a rising interest rate environment.
2. 2. Lack of growth.
3. 3. A short historic precedent of companies taking excess cash and letting it sit idle in a cash account.
We think all play a role but number three stands out as the biggest culprit.
Two examples of anchoring cash accounts come to mind: Microsoft’s market value has done nothing in the past 10 years while operationally the company has evolved itself into a force to be reckoned with—not that it ever lost its operational respectability. But the ballooning cash account has been an anchor to market value. With such excess cash, they would have to put a high percentage of it to work to escape the pitfalls of it sitting in a sweep account earning maybe 1%. And they probably don’t have any type of opportunity to deploy that type of cash with the exception of a big potentially messy acquisition.
The other example comes from close to us geographically: The Marcellus Shale area in Pennsylvania is producing overnight millionaires out of farmers who sold gas rights on their land. The typical pattern has been for the newly rich to deposit the money in a local bank and then do nothing. There is no economic activity being harnessed because the only new business is the gas companies. In other words, the new cash is dormant.
This dormant cash anchoring market values seems a logical reason for the high amount of companies exhibiting such high free cash flow yields. Or, it’s becoming meaningless to have a high free cash flow yield, what is important is what you are going to do with it. If a company can successfully deploy it to increase the growth and profitability of the company than the free cash flow yield won’t stay high for long. But if the cash is to remain dormant, market value will not benefit..