CHERYL RAVELO
The Dow Jones Industrial Average is no longer a bargain, according to one fundamental valuation measure. As of Friday's close, the liability-adjusted cash flow yield (the anticipated rate of return through which all of a company's debts and liabilities are proportionally assumed into the purchase price of the stock) of the SPDR Dow Jones Industrial Average ETF is 4.03 per cent. Divide this figure by the 2.82 per cent yield of a 10-year U.S. Treasury Note and the resulting margin of safety ratio is a scant 1.43 (a ratio greater than 2 is desirable).
In light of these figures, bond and index fund investors should prepare for total-returns below historical averages. However, "stock pickers" should be able to generate satisfying long-term returns by selecting equities with attractive valuations, strong returns on invested capital and a durable competitive advantage.
Last week we focused on the 10 Dow stocks with the least attractive valuations -- a portfolio of companies that suffer from weak or irregular cash-flows, excessive debt burdens, and possibly, a damaging speculative interest. This week we highlight the 10 Dow stocks with the largest (most-attractive) liability-adjusted cash-flow yields (using 10-year historical data).
Some of these stocks may trade at valuations that scream "buy," but remember, the true merit of any investment rests in the stability (and ideally, growth) of future cash flows. In this regard, you the investor must form your own considerations and conclusions.
10. 3M
Liability-Adjusted Cash Flow Yield: 4.4 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 1.56
Return on Invested Capital: 22 per cent
Dividend Yield: 2.4 per cent
3M is a great company trading at a fair price. This "Dividend Aristocrat" has delivered stable returns for investors for the last three decades. With a 22 per cent return on invested capital (no easy feat for a $62-billion company), the manufacturer of Post-Its and Scotch Tape continues to deploy capital wisely.
At a March 2009 low of $41.83, 3M was a slam dunk investment. At around $90, 3M is no longer a bargain, but is still among the most attractively priced stocks in the Dow (and arguably, a better income investment than U.S. debt).
9 . Hewlett-Packard
Liability-Adjusted Cash Flow Yield: 5 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 1.77
Return on Invested Capital: 22 per cent
Dividend Yield: 0.7 per cent
Hewlett-Packard's stock is in a multiyear convalescence following the theatrics surrounding the HP-Compaq merger of 2001 and the forced departure of Carly Fiorina -- an embattled and unloved CEO.
H-P has delivered strong (albeit inconsistent cash flows) for the last five years, but forward-looking investors must consider the company's mobile strategy. Earlier this year, H-P acquired Palm for $1.2-billion (presumably, for Palm's WebOS) -- but at this point, H-P's role in the mobile revolution is unclear.
The computing giant's valuation is among the bottom third in the Dow, but does not fully discount the uncertainty surrounding the future (and competitiveness) of the mobile computing landscape.
8. IBM
Liability-Adjusted Cash Flow Yield: 5.4 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 1.91
Return on Invested Capital: 40 per cent
Dividend Yield: 2 per cent
Since the 1970s, both IT managers and money managers have spoken a now-classic adage, "Nobody ever got fired for buying IBM ."
Long considered a defensive stock, IBM has shifted back into growth mode, delivering impressive year-over-year cash flow gains since 2006. Assuming that the IT bellwether can continue growing cash flows into the future, IBM makes for a very compelling investment at today's valuation (despite being near a 10-year high).
Yet for the average investor, IBM almost certainly falls into the category of too-complex-to-understand. The company's blend of hardware, software and outsourcing products is both global and robust, but a truly cautious investor should heed Warren Buffett's advice -- don't buy what you don't understand.
7. Cisco
Liability-Adjusted Cash Flow Yield: 5.5 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 1.95
Return on Invested Capital: 55 per cent
Dividend Yield: N/A
Cisco is a "no-longer-sexy" tech company that deserves far more love than it receives. The $140-billion data-networking giant delivers a 55 per cent return on invested capital (an extremely high figure for a company that makes physical goods), strong (and growing) cash flows, and holds nearly $40-billion in cash and cash equivalents.
After a precipitous decline following the dot-com crash, Cisco's shares have failed to break out of a trading range -- but patient investors have something to look forward to: Cisco CFO Frank Calderoni has recently affirmed his commitment to rewarding shareholders with a dividend.
In the meantime, Cisco's share repurchase program should deliver value to shareholders (considering the company's below-average valuation).
6. ExxonMobil
Liability-Adjusted Cash Flow Yield: 5.5 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 1.95
Return on Invested Capital: 16 per cent
Dividend Yield: 2.8 per cent
Exxon Mobil has the rare (and head-scratching) distinction of being the most profitable and most attractively valued company in its industry.
The stigma attached to the Deepwater Horizon spill has allowed investors to scoop up Exxon shares for less than their March 2009 lows. Investing in this oil giant is neither a sexy nor original idea, but Exxon has rewarded shareholders for a century and is well-positioned to deliver shareholder returns into the future.
5. Pfizer
Liability-Adjusted Cash Flow Yield: 5.5 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 1.95
Return on Invested Capital: 8 per cent
Dividend Yield: 4.4 per cent
Pfizer is an attractively valued company -- in a "pro-forma" sort of way. From 2005 to 2009, the pharmaceutical-giant's tax rate averaged 4 per cent -- a figure that deserves questioning.
According to Bruce Berkowitz of Fairholme, "low tax rates based on offshore businesses" were the catalyst for his decision to lighten his position in Pfizer. If Pfizer's effective tax rate was to normalize (which will happen when offshore capital is repatriated, as Mr. Berkowitz states) -- Pfizer's valuation will become less attractive -- quickly.
4. General Electric
Liability-Adjusted Cash Flow Yield: 5.7 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 2.02
Return on Invested Capital: 16 per cent
Dividend Yield: 2.9 per cent
General Electric's massive dividend cut in February 2009 coincided, almost perfectly, with the recession's market bottom. During the following week, investors had the opportunity to purchase GE stock for $7 (yielding a liability-adjusted cash flow of around 8 per cent). In the 18 months that followed, GE's stock has more than doubled, and while still attractively valued, investors must grapple with a few items:
As of last quarter, General Electric holds $478-billion in debt -- a figure greater than the external debt of most countries.
Over the last five years, GE's effective tax rate has been less than 15 per cent. Is this really a sustainable figure?
GE's expansion into the world of finance has made the industrial titan an extremely difficult company to analyze.
These issues make General Electric fun to watch, but not fun to own.
3. Johnson & Johnson
Liability-Adjusted Cash Flow Yield: 5.8 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 2.06
Return on Invested Capital: 24 per cent
Dividend Yield: 3.6 per cent
Johnson & Johnson's valuation has been driven down in recent months due to a large-scale recall of children's medicine by J&J's McNeil Consumer Healthcare division and a disappointing full-year guidance.
With a 3.6 per cent dividend yield, Johnson & Johnson offers one of the highest yields in the Dow -- but the health care giant's margin of safety may quickly condense if it is unable to maintain below-average tax rates.
2. Intel
Liability-Adjusted Cash Flow Yield: 6.3 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 2.23
Return on Invested Capital: 26 per cent
Dividend Yield: 3 per cent
On Wednesday, Intel reached a settlement with the FTC, resolving a pending antitrust case. Accused of using illegal sales tactics to monopolize the chipmaking industry, Intel's settlement echoes Microsoft's anti-trust woes of a decade past.
Intel's similarities to Microsoft don't end there:
Both companies are flush with cash (as of last quarter, Intel holds $16.3-billion in cash, Microsoft, nearly $40-billion),
Both companies stock prices have flat-lined for a decade.
Neither company has a clearly defined mobile strategy.
Intel is a powerful company, and will likely emerge from its antitrust woes unscathed. Yet until Intel embraces the mobile revolution in a meaningful way (organically, or by acquisition), there are few catalysts to drive Intel's shares up. In the meantime, income investors may wish to collect one of the safest dividends in the Dow.
1. Microsoft
Liability-Adjusted Cash Flow Yield: 7.3 per cent
10-Year Treasury Yield: 2.82 per cent
Margin of Safety Ratio: 2.59
Return on Invested Capital: 334 per cent
Dividend Yield: 2 per cent
Microsoft owns a virtual-monopoly in the enterprise software market, providing it with an eye-popping 334 per cent return on invested capital and strong, stable cash flows. Unfortunately, this has meant little for investors.
Microsoft's noncore product offerings (Zune, Bing, Kin, etc.) have been viewed as second-rate efforts, leaving both investors and analysts disappointed (the Kin was scrapped a few weeks after being brought to market).
With nearly $40-billion in cash and cash equivalents, Microsoft has ample capital to fund R&D projects, buy back shares and offer a much larger dividend than it currently pays.
Ultimately, if CEO Steve Ballmer cannot reward shareholders, the greatest returns for shareholders may come the day that Mr. Ballmer steps down.