VALUE: After Hours (S07 E20): The Reinvestment Engine: High Free Cash Flow + Smart Management

During their recent episode, Taylor, Carlisle, and John Huber discussed The Reinvestment Engine: High Free Cash Flow + Smart Management. Here’s an excerpt from the episode:

John: All right. T.C. Toby’s one of my favorite TCs. See, there’s three things– If you can find these three ingredients in a stock– I think it’s very rare, but if you can find a high free cash flow yield and you can find a durable business where you can look out, say 10 years– I call it 10 -year tests. You look out 10 years and you say, “Okay, I can visualize what this company is going to be doing. I can get a certain level of conviction around their competitive position a decade out.” So, it doesn’t mean a long growth runway or a fast-growing runway, but just a durable stream of cash that you can predict. So, that’s the second.

And then, the third, and this is the part that makes it rare, is a management team that understands that the value of that high free cash flow yield. The common conflict is management is worried about entrenching themselves or making acquisitions, growing their empire instead of buying back shares. If you can find a stock that trades at a 15% or a 20% free cash flow yield, which is relatively rare, obviously, but if you can find that and you can couple that with, again, a durable business with a management team that uses the free cash for buybacks, what you effectively create is a reinvestment engine, right?

So, you can buy stock in a growth stock that– Let’s say, a classic Peter Lynch growth stock that’s a retail chain that’s growing its store footprint and investing into– Taking all of its earnings– Walmart or a Starbucks back in the day where they would take all of their earnings, they’d put up a new box, they’d earn 30% cash on cash returns, and it was just this fabulous growth story. But that requires an enormous amount of execution. It requires a big moat and it’s possible to find those.

But I think a lot of people undervalued these, I’ll call them like these high free cash flow yields, because they see the growth as like mediocre or– Maybe it’s consistent but it’s not growing. Or, there’s always the worry that it’s a value trap, what about these flows? Is the market ever going to go from 5x to 10x? Well, you don’t need to worry about it. If it’s trading at 5x and the management– If the multiple never moves, it’s actually an advantage for you, because you can create that reinvestment engine where on a per share basis, you’re getting a 20% compound annual growth rate on a per share basis. And so, that is actually more attractive to me than the classic reinvestment engine where you’re going out and expanding your business.

Because the reason is it’s more attractive is because they don’t need to do anything different. The management team from an operational perspective just has to keep doing what they’re doing now. They don’t need to execute on this huge growth plan. They can just buy back shares. So, it’s just really interesting to think about– I think at least right now, that’s where more opportunities are.

Not to say there’s not great growth stocks. There always will be great growth stocks. But 10 years ago, we’ve talked about this before. I think the three of us have chatted about this last time, but it is true that multiples have gone up a significant amount and part of that is due to the index flows and part of it’s due to I think the trade deficit, which is a capital account surplus on the other side of the coin, which means more and more money from foreigners are coming into the country and they need a place to put their money, and it goes into treasuries and it goes into the S&P. Foreign ownership of the S&P has doubled in the last decade, I think largely because stocks are going up and the S&P is a very liquid place for large foreign investors that have dollars– It’s an easy place for them to put their money.

So, those stocks, they’re just not going to offer the same yield that they did 10 years ago. And so, I think the opportunities are seeking out these stocks that are outside of the index perhaps. Some of them might be in the index, but for whatever reason, they’re undervalued. I think people should stop worrying too much about, like whether it’s a value trap and just focus more on trying to find the management teams that are allocating capital in a way that you would if you were running the business. Those are hard to find, but they are out there. So, that’s where I’ve been spending more of my time.

Tobias: Let me give a quick shout out to everybody at home. Toronto. San Rafael. Petah Tikva, Israel. What’s up? Temecula. Portsmouth, New Hampshire. Rochester. Bellevue. Bremerton. Dubai.

JT, we come right to the top of the hour. Do you want to do your-

Jake: Yes, sir.

Tobias: -veggies for John?

Jake: Veggies for John. All right.

John: Yeah. Yeah. Serve them up, Jake.

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