Dear Fellow Investors:
At Smead Capital Management, our fourth criterion for stock selection is the generation of high levels of free cash flow. To us, long duration common stock ownership is very similar to owning an entire business. In our opinion, the free cash flow represents the money the owner receives which does not have to be plowed back into the business to perpetuate its success. In effect, we believe it is the “real” and measurable wealth creation of the business.
We think the best way to help you understand the importance of free cash flow is to recount a story we have heard many times. Supposedly, when Warren Buffett was raising money for one of his early partnerships, he went to visit the owner of the largest farm implement dealership in Omaha. Warren, the story goes, knew that it had been a prosperous year in farming and that the owner was an influential business person. He asked the man how the year had been and the owner said, “We had a very good year this year.” Warren said, “what did you do with all the money you made?’ The owner of the business walked over and pulled open the drapes and said, “It’s all in next year’s inventory!” Mr. Buffett quickly concluded that when a business has a banner year and the owner isn’t awash in free cash flow, it’s not a great business to own.
We screen for companies that generate high free cash flow and have produced it consistently over time. We like to see high cash flow on a relatively non-cyclical basis and don’t want to be deceived by boom times in a business or an industry. We will highlight a few of our existing holdings which are selling at low prices in relation to free cash.
Pfizer is one of the largest pharmaceutical companies in the world. We are convinced investors are unaware of how conservative the accounting is for this industry. In 2013, Pfizer expensed 12.9% of its sales on research and development. For most businesses, this would get capitalized because it is spending on long-term business creation. Despite this, Pfizer trades at a free-cash flow yield of 7.9%, a tidy amount available to us if we owned the entire company. Stock buybacks and dividends are a common way that a company like Pfizer rewards it common stock owners.
Medtronic, one of the world’s largest manufacturer of implantable biomedical devices, trades at a free-cash-flow yield of 7.67%. As aging baby boomers move into their 60s and 70s, we believe there should be a steady flow of new customers with high net worth to pay for Medtronic’s life extending technologies. It seems to us that they are using the free cash flow to raise their dividend every year and have been regularly buying back stock. Consider, that Value Line estimates a $1.20 dividend this year; it was $.13 in 1998!
Free cash flow is not a complicated accounting factor. We at Smead Capital Management just respect its value and the way in which we believe it affects the long-duration results of being a part-owner of a meritorious business.
William Smead
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
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