If You Can’t Kill It, Buy It

One of my favourite investment quotes comes from Bruce Berkowitz, who manages the successful Fairholme mutual fund. “If you can buy a company with a free cash flow yield of 10% or better and you can’t figure out how to kill it, you should buy its stock all day”. Free cash flow is the excess cash that a business generates after all payments are made to run the business. The free cash flow yield is simply the amount of free cash flow* generated by a company in a given year divided by its market capitalization. In an environment where cash earns you nothing and government bonds pay you 2%, a 10% free cash flow yield is very attractive. The free cash flow can be used by management to pay and increase dividends, buy back stock or look to make acquisitions. Companies that generate a lot of free cash flow make excellent take over candidates. They are often targeted for leveraged buyouts, as the cash generated can more than amply cover the cost of acquisition, especially in a low-interest rate environment.

Finding a company that offers a free cash flow yield of 10% or more is the easy part. Any stock screener will help with that. Finding a worthwhile investment candidate is another story. A company that offers a high free cash flow yield usually brings along wrinkles and warts. The high-yielder may be in a business that is in terminal decline, may have an over-leveraged balance sheet, or be in cyclical business that may look good today only to be in trouble in a few years. The market doesn’t give away 10% free cash flow yield for free, so you have to do your homework and ask the basic question, “will this company still be in business 10 years from now?”

Eyes may roll at the following three picks but you have to keep in mind that these names are cheap for a reason. I am hopeful that these companies will eventually return to investor favour and in the meantime, you can collect healthy dividend payments. All offer free cash flow yields of more than 10% - they all have good balance sheets, rising dividend yields, and most importantly, we can’t figure out how to kill these businesses dead.

Staples is facing aggressive competition from the likes of Amazon and Costco, not to mention a recently announced merger of Office Depot and Office Max. Staples has a sustainable advantage in that it offers next day business-to-business delivery of office products which generates over 80% of its sales. The company has taken steps to rationalize its business by cutting the cord on under-performing stores, and is focusing on its online division efforts. Free cash flow has been used to rapidly reduce its share count and increase dividends. The current yield is 3.4% and a dividend increase is expected next month. The stock trades for less than 10 times earnings.

Cisco has become a toll road business that supports the ever-growing demand for bandwidth. In spite of fierce competition, Cisco continues to generate strong gross margins and has recently increased its market share. Since announcing its first dividend payment in March 2011, Cisco has rewarded shareholders with a 130% increase. Its current dividend yield is 2.7%. Cisco trades at 10 times earnings and less than 8 times earnings if you exclude the cash balance.

Teva Pharmaceutical is the most unloved pharmaceutical company. Teva generates most of its revenues from generic brands, but has a sizable exposure to a number of branded blockbuster drugs that will come off patent protection in a few years. The company has a strong pipeline but a recent earnings slowdown has hurt its stock price. Trading at a mind-boggling 7 times this year’s earnings, Teva offers investors a 2.8% current yield and is actively buying back shares.

*free cash flow is net income plus depreciation and amortization minus capital expenditures

Disclosure: The author and clients of Baskin Financial Services own shares in Staples, Cisco and Teva.