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By Will Ashworth
| November 11, 2016
This bull market brings me back to the dot-com bubble in 2000, when stocks flaunted such outrageously high price-to-earnings ratios that you could get a nosebleed just by buying a tech stock.
The S&P 500 is on its eighth consecutive year of positive returns — a truly amazing feat. And yet there are many who are convinced the bull market will continue because historically low interest rates (for so long) have rendered the traditional valuation metrics useless.
Epoch Investment Partners Managing Director William Booth believes that one method for determining whether a business will increase or decrease in value in the future is to find companies that are growing free cash flow over time and successfully allocating it. (Free cash flow is a company’s earnings plus depreciation and other cash charges, minus the capital expenditures necessary to maintain the business.)
So, rather than finding companies with high P/E ratios, I’m looking for companies that have low free cash flow yields and that have generally done a mediocre job of growing it.
Doing so produces a group of seven S&P 500 stocks that are destined for lower prices soon. Thus, you should be paring them from your portfolio, or even considering them for bearish plays.
Free cash flow yield: 1.8%
When you compare FedEx Corporation with United Parcel Service, Inc. (UPS) in terms of long-term performance, it’s not hard to figure out who investors seem to prefer.
FDX stock has delivered a total return of 16.6% over the past five years, which is 530 basis points higher than UPS. So far in 2016, Fedex is beating UPS by 7.5 percentage points. But past performance isn’t what matters going forward.
UPS has higher operating margins than FedEx and generates far more free cash flow as a percentage of sales, and its free cash flow yield is currently 5.1% — more than double FedEx’s.
From a valuation perspective, it seems obvious that UPS is the better buy. Yet investors are willing to pay 26 times earnings for FedEx stock compared to 19 times earnings for UPS. Eventually that differential is going to narrow; either by investors paying more for UPS or less for FDX.
I believe it’s going to be the latter. And soon.
Free cash flow yield: 1.7%
Martin Marietta Materials, Inc. provides crushed stone, sand and gravel to the construction industry. However, it was part of Lockheed Martin Corporation (LMT) for just 18 months, and the defense giant took no time hiving off the piece of MLM it didn’t need when it merged with Martin Marietta in the mid-1990s.
On Nov. 1, MLM announced third-quarter earnings that were 36% higher than a year earlier. Revenues also were up a respectable 2%. The company is benefiting from an improving economy, and that has the stock up nearly 45% year-to-date. That’s the good news.
The bad news? I don’t believe it can sustain this upward trajectory.
Martin Marietta’s stock is two months away from booking a fifth consecutive year with positive returns, and in the process it will have beaten the S&P 500 in three of those years. Impressive to say the least. Its market cap since 2011 has grown by 250%, while its revenue and free cash flow have grown 117% and 165%, respectively.
While these revenue and free cash flow numbers are good, I just don’t seem them being worthy of a sixth or seventh consecutive year of positive gains. In 2017, I see a decent-sized correction in its stock price.
Ken Lund via Flickr
Free cash flow yield: 4%
Colgate-Palmolive Company reported third-quarter earnings Oct. 27, and they weren’t anything to write home about.
Revenues were down 3.5% year-over-year to $3.87 billion — $70 million less than analysts were expecting and $132 million lower than in the same quarter a year earlier. As a result of declining revenues in the quarter, Colgate’s operating profits were also lower by 5.7% to $1.07 billion.
Colgate, like many U.S.-based companies operating globally, is having difficulties coping with the strong U.S. dollar. That said, its organic sales grew by 4.5% on a global basis in the quarter on very strong results from emerging markets.
So, depending how you look at Colgate’s situation, the glass is either half-empty or half-full.
From a valuation perspective, I can’t help but think that investors are giving CL credit for its growth efforts and a pass on its foreign currency issues. Over the past five years, Colgate’s free cash flow hasn’t changed much. It generally comes in around $2.5 billion annually, but its market cap has grown by 57% over the same period.
Organic sales growth aside, Colgate’s operating margins have eroded in the past five years, yet its market cap has increased substantially.
If that’s not the sign of an overvalued stock and market, I don’t know what is.
We’re coming up on three years since Pfizer Inc. (PFE) spun off Zoetis Inc., its animal health business, into its own publicly traded, independent company. At the time, Pfizer’s CEO wanted to focus all of the company’s efforts on its core human drug development business, leaving it two choices: sell Zoetis or take it public.
Three years later, Pfizer appears to have made a brilliant decision, as Zoetis stock is up 23.5% on an annualized basis.
Four months after its IPO, Pfizer offered existing shareholders the opportunity to exchange some of their existing Pfizer shares in a tax-free deal for some of the company’s 80.2% interest in Zoetis. Since Pfizer announced its offer to existing shareholders in May 2013, Zoetis stock is up 45.6% compared to no gain for Pfizer’s stock. Anyone who made the exchange has done well.
But here again, like the situation with Colgate-Palmolive, Zoetis’ annual free cash flow has remained around $440 million over the last three years while its market cap has doubled. While Zoetis projects earnings per share to grow to $2.22 in 2017 on $5.27 billion in revenue, unless it can do something about its free cash flow, any earnings disappointment will hammer its stock.
The easy money has already been made.
Free cash flow yield: 2.4%
Former E I Du Pont De Nemours And Co. CEO Ellen Kullman recently spoke at Fortune magazine’s annual Most Powerful Women’s conference. At the top of her agenda was a veiled critique of the pending $60 billion merger between her former company and Dow Chemical Co. (DOW).
Although Kullman wasn’t talking about the two companies specifically, the fact that she spoke out against this type of merger — which is only being done to then turn around and break it up — is a complete waste of time and does little for long-term shareholder value.
“Break up, recombine. Break up, recombine,” Kullman told Fortune’s Pattie Sellers at the California conference. “That doesn’t create any value except for bankers and lawyers.”
Since the two companies announced their merger last December, Dupont’s stock has been on a rollercoaster ride. DD droped into the low $50s in late January before rebounding into the $70s by August — exactly where it was before the deal announcement.
DuPont stock trades at 30 times free cash flow. Dow trades for a little more than that. It will take time to split the merged entity into three parts, and when that finally happens, there’s no guarantee that investors will be buyers.
The downside appears greater than the upside on this one.
Free cash flow yield: 3.3%
It’s not often I go with two stocks from the basic materials sector, but here we are.
By almost every metric, International Flavors & Fragrances Inc. stock is more expensive today than it was five years ago. To a certain extent, it’s understandable. The company’s operating earnings are 41% higher since 2010 on just a 15% increase in revenue. IFF is making more from every dollar it generates in sales, and investors have been rewarded as a result.
Since 2014, IFF has been on a bit of an acquisition binge spending almost $500 million picking up companies that can strengthen is stranglehold on the global flavors and fragrance markets. You probably use or consume at least five products each day that have their handiwork incorporated into the taste, feel or smell of those products, without which, you would have never bought them in the first place.
IFF announced Nov. 3 that it was acquiring Fragrance Resources, a privately owned company with $75 million in annual revenue. No terms were disclosed, but the deal is expected to add to earnings starting in 2017.
This isn’t a bad company, it’s not a bad stock … but it is a bad valuation. IFF trades at 3.4 times sales, which is double what it was in 2010. Meanwhile, the S&P 500’s P/S has increased by just 46%. Meanwhile, the company’s debt is higher than it has been for most of the past decade.
IFF is priced for perfection, and we know the markets aren’t perfect.
Free cash flow yield: 3.6%
The Nov. 4 jobs report was the final tally of the U.S. employment situation before the the election, and it was a bit of a non-event. The economy created 161,000 jobs in October and the unemployment rate declined to 4.9%. Analysts were expecting 178,000 jobs and a 4.9% unemployment rate, down from 5.0% in September.
Although the report was ho-hum, any increase in jobs is good news for Automatic Data Processing, which specializes in providing payroll and human resources outsourcing to companies big and small.
More jobs = more revenue.
The company reported its first-quarter results Nov. 2, and they were better than expected. Revenues increased 7.5% year-over-year to $2.92 billion, with adjusted earnings jumping a whopping 26.5% from a year earlier to 85 cents per share. Solid numbers indeed.
So, what’s the problem with ADP’s stock price?
ADP hasn’t had a down year since 2008, when it was off by just 9% compared to 37% for the S&P 500. Reversion to the mean is bound to kick in at some point. Besides, all of its valuation metrics in the past two to three years have been at levels considerably higher than its historical norms.
At the end of the day, ADP’s revenues have increased considerably since it last had a negative return in 2008. However, its free cash flow has basically remained the same, meaning it’s spending more each year to generate the same dollar of earnings.
That’s never a good thing.
This article is from Will Ashworth of InvestorPlace. As of this writing, he did not hold a position in any of the securities discussed.
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