By now you’ve gotten the memo that it’s time to own value stocks, since value beats growth when consumer prices and interest rates rise.
But be careful, because not all value is created equal. So-called value traps are lurking out there. These are stocks that are inexpensive for the wrong reasons.
The losers these days will have weak earnings growth due to poor pricing power combined other problems like skyrocketing labor costs.
To beat the market, favor value companies with the following qualities, say strategists at Bank of America.
1. Inflation protection.
2. Limited vulnerability to possible negative economic trends.
3. High free cash flow to enterprise value (EV), relative to peers.
It’s obvious why you’d want inflation protection, typically in the form of pricing power. Limited exposure to surprise negative macro trends is key during uncertain times. But the importance of cash flow may be less intuitive.
Here’s why it’s essential to good value investing.
Three reasons why cash flow is king
1. Value investors love cash flow because it gives companies the flexibility to reward shareholders with dividends and share buybacks, says John Buckingham, a value investor who manages the Prudent Speculator investment letter. Dividends can be a big part of return, in a sideways market. Cash flow also gives companies the freedom to invest without borrowing too much money.
2. Value mavens love valuation metrics based on cash flow, for these reasons. First, cash is pure, says Brian Barish, a value manager at Cambiar Investors. Cash flow is hard to fake. In contrast, earnings can be clouded by accounting adjustments. Price to book value has issues, too, notes Barish. Book value can miss the true worth of intangible assets like brands or real estate that went up in value.
While Bank of America suggests high free cash flow to enterprise value (market cap plus debt), Buckingham tracks a similar gauge called free cash flow yield. This is cash flow divided by market cap. In both cases, higher numbers mean cheaper stocks.
Companies with high free cash flow yield tend to perform well. This gauge regularly beat other valuation tools like price earnings or price to book, according to back tests performed by Buckingham.
“Free cash flow yield incorporates things that price-earnings ratios do not factor in,” says Buckingham. “It tells you how much money companies have to invest and reward shareholders.”
3. Value investors just have a thing for cash and predictable cash flow. It makes companies more valuable especially in uncertain times, says Chris Marangi, a co-CIO for value at Gamco Investors
“If a company has predicable, highly visible cash flow it should get a higher valuation compared to a more speculative company where the cash flow is less certain.”
“Cash flow is primordial,” says Barish, at Cambiar. “Why would you be in business if you weren’t going to earn a profit.”
Spoken like a true value investor. No disrupters plowing all their revenue back into some visionary dream, for these investors.
“We are not meaningfully playing in that end of the swimming pool. That’s one of the differences between a value mentality and a growth mentality,” says Barish.
It’s also what’s protected value investors from the kind of damage recently suffered by emerging tech investors like Cathie Wood at Ark Investment Management.
Here are five companies that look like they won’t turn into value traps because they have the qualities on the Bank of America checklist.
This cable company checks all the boxes on the list, says Marangi, at Gabelli. Besides operating broadband services in the U.S., NBCUniversal and theme parks, the company owns Sky broadband and broadcast networks in Europe.
“Because broadband is a quasi-utility, they have enormous pricing power which affords them inflation protection,” says Marangi. This also gives Comcast
protection against economic downturns. Next, this is a capital-intensive business so the labor portion of expenses is relatively low. Despite these advantages, Comcast shares have been weak because of fears of competition, but Marangi thinks this threat is already priced into the stock.
Comcast has a reopening kicker since visitors will return to theme parks, and Sky sports subscriptions will be reconnected in European pubs that cut their service during the pandemic. The stock trades for an enterprise value of 6.7 times 2022 cash flow (EBITDA) compared to nine times at Charter Communications
This is the inverse of cash flow to EV. So, lower means cheaper.
To find cheap value stocks based on cash flow valuation metric, Buckingham screened all his current stock suggestions to find the ones with the highest free cash flow yield. A higher value means a stock is cheaper. One that really stands out is CVS Health
It has a free cash flow yield of 11.4% compared to 4.3% for the S&P 500 and 4.9% for the Russell 3000 value index.
CVS operates more than 9,900 drug stores and over a thousand walk-in medical clinics. It’s also a pharmacy benefits manager, and a health and life insurance provider through its Aetna division. Since it sells pharmaceuticals and consumer staples that people typically consider essential, it offers protection against economic downturns, says Buckingham. He thinks growth can come from the managed care side of the business.
This pharmaceutical giant has among the highest free cash flow to enterprise value in portfolios managed by Barish, who oversees the Cambiar Opportunity Fund
and the Cambiar Aggressive Value Fund
He also helps manage another fund at Cambiar. The company generated $15 billion in free cash flow last year. It has an enterprise value of $180 billion, for a free cash flow to EV value of around 8%. That’s higher than most pharmaceutical companies. Bristol-Myers Squibb
has predictable revenue and pricing power since it sells patented and essential products. It can post fundamental growth because of its pipeline.
Formerly Viacom, this broadcast and cable and streaming service provider now known as Paramount Global
operates Paramount+, Pluto TV, CBS, Showtime Networks, Paramount Pictures, Nickelodeon, MTV, Comedy Central and BET. The legacy media business produces lots of cash flow. The growth and pricing power come from the subscription services and price escalation clauses on content sold to cable companies, says Marangi, at Gabelli. It trades at an enterprise value to cash flow (EBITDA) ratio of around six times, compared to 23 at Netflix
Liberty Braves Group
This is a John Malone tracking stock that gives you exposure to the earnings power and residual value of the Atlanta Braves baseball team, its ball park and related real estate. You can’t argue that Liberty Braves Group
looks relatively cheap by cash flow metrics, since there are no other publicly traded baseball teams. But the tracking stock looks inexpensive considering a looming catalyst that could make the stock jump quite a bit, says Marangi. More on this in a second.
But first, the Braves have pricing power and predictable revenue because of the scarcity value of its business. There are only so many big-league sports franchises. This means it can take steady price increases on seats, suites, concessions and broadcasting rights. “Sports assets are reliable stores of value and economically resilient because of the scarcity of the number of teams,” says Marangi. Now that Major League Baseball and the Players Association have struck a deal, the risk of a prolonged strike is gone.
The catalyst? Malone may soon spin out the team and real estate to tracking stock owners. Here’s that math that suggests this will create a nice payoff for tracking stock owners like Gabelli. Liberty Braves Group has an enterprise value of $1.9 billion and its real estate is probably worth $500 million, which means tracking stock owners currently have the Braves team at $1.4 billion. In contrast, the Mets sold for $2.4 billion in 2020.
Michael Brush is a columnist for MarketWatch. At the time of publication, he owned NFLX. Brush has suggested NFLX and BMY in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.