I have even higher expectations for two recent purchases, Merck (NYSE:MRK - News) and Coca-Cola (NYSE:KO - News). Merck is such a table-pounding buy that I think it is the best value I've found in the last four years. My expected return from Coke is not quite as high, but I believe it is more certain. In this article I'll describe how a bear picks stocks, and why these two companies pass every test.
A bear considers the worst possible outcome first: Can this stock go to zero?
A portfolio is much less likely to provide adequate returns if even one of its holdings suffers a total loss. Merck and Coke are very large enterprises that consistently generate operating earnings far in excess of their interest payments. They each have durable businesses and substantially more tangible assets than debt. The probability that either will face bankruptcy is virtually nil.
In fact, Merck and Coke have two of the strongest balance sheets among all publicly traded companies. This is especially important to a value investor because most companies in the bargain bin get there because they encounter problems. Merck faces a liability related to Vioxx, an arthritis drug with cardiac side effects, that might cost it billions of dollars. However, we think the company has the financial resources to overcome this setback.
Bears preparing for a long winter get fat on quality companies.
Patient bears make most of their money on the arbitrage between their long-term outlook and the short-term horizon of their competitors. In the stock market, even five years is a short period. In Yes, You Can Time the Market, Ben Stein provided historical data showing that value-conscious stock purchases would have generated substantial excess returns when measured over a 10- to 20-year period. However, at the five-year mark the results were much less convincing
A long-term outlook is practical only if the company under consideration has a stable business with durable competitive advantages. Borrowing a concept from Warren Buffett, Morningstar calls these competitive advantages an economic moat. Patents and strong brands help to create wide moats, and consistent returns on invested capital greater than weighted average costs of capital provide evidence that a moat is present. Wide-moat companies increase real (adjusted for inflation) shareholder value over the long term, and Merck and Coke are championship contenders in this regard.
Bears perform a reality check on their projections
For stable, wide-moat businesses, the past is a useful guide to future results. I calculate the average free cash flow (cash from operations minus capital expenditures) and dividends per share for three-year periods at both ends of the last decade. Using a financial calculator, I then compute the compound annual growth rate between the periods. I'm reluctant to estimate future results that stray too far from what was achieved in the past.
During the last 10 years, Merck's compound annual growth in normalized free cash flow was about 11.6%, and its dividend growth was about 11.7%. Coke grew free cash flow at about 7.5%, and its dividend at 8.9%. Because inflation during this period was about 2.5% to 3%, that amount can be subtracted from these figures to approximate real growth. Both of these metrics should parallel real earnings per share (EPS) growth over the long term, but the broad market's real EPS growth from 1871 through 2001 was only 1.25% (according to Jeremy Siegel in Stocks for the Long Run). If Merck and Coke do roughly as well in the next two decades as in the last one, that would constitute outstanding long-term growth.
Bears won't bite unless the stock is cheap.
At Morningstar, we value stocks with complicated models built on many projections, but investors can assess the value of mature, wide-moat companies pretty well with a few simple calculations. One of my favorites is the free cash flow yield. This is free cash flow divided by enterprise value (market capitalization plus net debt). I calculate this conservatively by using the average free cash flow from the last three years.
The free cash flow yield at Merck is about 9.7%, and the figure at Coke is roughly 4.2%. Remember that free cash flow grew at 11.6% and 7.5% respectively during the last decade. A repeat performance during the next 10 years would provide Merck owners with a 21% nominal return, and Coke owners with almost 12% per year. By contrast, I believe the S&P 500 is currently priced to provide a return of only 5% (assuming 3% inflation) even though Merck and Coke are much better companies than the average member of that index.
Bears say, "Show me the money."
For a controlling shareholder, a company's value doesn't depend on its dividend policy, but the rest of us can't remove money from a company to suit our needs, and we can't prevent managers from wasting our capital on empire-building. Although I'd trust a few managers to retain all earnings and allocate the capital effectively, I require most of them to pay me a healthy dividend. Don't worry that this will limit earnings growth; in the Financial Analysts Journal, Rob Arnott and Cliff Asness showed that higher dividend payouts reliably precede higher earnings growth. Like a regular exercise regimen, dividend payouts provide a discipline that seems to make most companies stronger.Merck's prospective dividend yield is about 4.9%, and Coke's is roughly 2.5%. Remember that dividends grew at 11.7% and 8.9% respectively during the last decade. Another 10 years like the last 10 would provide Merck owners with a nominal return of 16.6% in dividends alone. Coke owners would receive 11.4% per year.
In my opinion, a total real return of 6% from either company would be a very satisfactory result given that Treasury Inflation-Protected Securities and the broad stock market are priced to yield near 2% in real terms. This means that operating results in the next two decades could be substantially worse than the last one without causing a disappointment. That's a margin of safety even a bear can love.