Grubhub, Chewy, and Pinterest shares are among the market’s worst performers since midyear. The Medicines Co. and Universal Forest Products have shined. That can mean only one thing: Whimsical company names have finally fallen out of favor. Plain-stated is hot.
Forget the FANGs. Based on names alone, look into the SIPs: Safety Insurance Group, Installed Building Products, and Packaging Corp. of America. Not to brag, but I’m pretty well positioned for this shift. I work for a news corporation called News Corp.
Looking for a stock-picking strategy with more analytical rigor? Have it your way. Morgan Stanley recently put a team of quantitative strategists to work determining which stock signals have tended to best predict performance over time.
These are super-mathletes who throw around terms like agglomerative hierarchical clustering algorithm—a way to tell which measures predict returns in similar ways. They looked at 4,000 stocks going back to 1997, because that’s about when high-quality data first became available worldwide. They focused on factors like price/earnings ratios, revenue growth, leverage, and share-price momentum—81 in all. My groundbreaking work on name frivolity never came up, if you can believe it.
Some key takeaways: Don’t give up on value stocks, but consider changing the way you look for them. Also, dividends are a welcome sign, but total capital return, including dividends and stock buybacks, has more predictive power.
Many investors have wondered whether value investing is dead, because buying U.S. stocks with low P/E ratios has been a lousy strategy for some time. But the 22-year record for low-P/E stocks is much better than the five-year one. The recent poor performance has been largely confined to the U.S. and Japan. And most important, an alternative measure of value based on free cash flow rather than earnings has done much better, trouncing a composite of growth factors and other value factors over the past five years and 22 years.
Free cash flow is the money that a company collects each quarter after paying for expenses and big-ticket investments. Earnings, meanwhile, are calculated based on a series of what-ifs. For example, what if money spent on a big investment were subtracted only little by little from earnings each quarter? Earnings are meant to show stock investors a neat story that matches spending with resulting revenue over time. Free cash flow is the real money a company can put to work.
As it turns out, all that tidy storytelling has less predictive power for stockpickers than simply counting dollars. Worldwide, a portfolio that bought stocks with the lowest P/Es and bet against those with the highest ones beat the market by an annualized 4.4 percentage points a year over the past 22 years, but just 0.8 points over the past five. The best value performer was free cash flow divided by a company’s enterprise value, which is stock market value adjusted for cash and debt. The measure beat the market by 8.3 points over the past 22 years and 3.7 points over the past five. Worldwide, a composite of growth factors beat the market by barely anything over the past 22 years and less than 1 point over the past five.
Separately, a stock yield that incorporates dividends plus buybacks predicted better performance than one based on dividends alone. That makes sense, because buyback spending has lately eclipsed dividend spending.
The study included plenty of steamy details about efficacy and persistence. It totally left me in the mood to call up my own stock database and screen-it-like-I-mean-it. So I searched the S&P 500 index for stocks with high estimated free cash flow in their current fiscal year as a percentage of enterprise value, along with healthy dividend and buyback yields. A handful of names stood out.
Delta Air Lines (ticker: DAL) and Cisco Systems (CSCO) have free cash yields of 7% to 8% and spend the bulk of the money on shareholders via dividends and buybacks. All three dominant drug wholesalers— McKesson (MCK), AmerisourceBergen (ABC), and Cardinal Health (CAH)—scored well, suggesting that their opioid legal risks are offset by plenty of cash generation. Drugmaker AbbVie (ABBV), which could face generic competition for a key arthritis drug in a few years, is a much bigger cash cow than tobacco king Altria Group (MO), which faces continued declines for smoking. Viacom (VIAB) and Charles Schwab (SCHW) have FCF yields of over 8%, compared with a median of 3.9% for S&P 500 companies.
CVS Health (CVS) beat earnings and revenue estimates and raised guidance on Wednesday, and shares rose 5%. That’s three quarters in a row of big gains following financial results. The stock has returned 39% since Barron’s recommended it in an April cover story, versus 9% for the S&P 500.
CEO Larry Merlo stopped by Barron’s this past week. He talked about how Aetna gives CVS a built-in hedge because of the way it benefits from falling health-care prices. Over time, CVS can send more Aetna patients to store clinics for routine care. Its HealthHUB store model, now eight months into testing, offers expanded services, including in-house blood labs for quick test results. Merlo says HealthHUBs are seeing increased prescriptions, front-of-store sales, and margins versus regular stores.
How much higher? I asked him. We’ll turn qualitative findings into quantitative ones soon, he said. But I’m impatient, I told him. Now you sound like an analyst, he said. CVS plans to have 50 HealthHUBs open by year end and 1,500 by the end of 2021.