Terry Smith explains: the free cash flow yield

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01. i think the most frequently asked question that i get from investors or potential investors is well the fund has done very well in their opinion and uh as a result doesn't it mean all the companies you invest in are very expensive and we shouldn't really be investing any more money uh in these companies and uh and discussed they say and there are a lot of things to say about that i mean probably the most important thing upfront is they might be right um i don't haven't got some great insight into what's going to happen in the world next i'm i'm absolutely certain we own a portfolio of very very good companies um but i can't tell you what will happen next in any of their share prices and you know as a great man once said if you think you can give me a call could be very useful but i'm not alluding to that um we track a number of things to try and see whether or not we think there's still value there because we like to believe that in the event that we didn't think that there was any value from continuing to invest in these companies we'd stop basically because we think it would be the only reasonable thing to do one of the key measures we look at is the free cash flow yield of these companies which is sounds a little technical for for the non investment professional but isn't really it's the amount of cash the jet that the companies generate after all their expenditures each year divided by their market value because we take the view that we own those cash flows they may not pay them all back to us as dividends they may reinvest some of them in the business to grow the business most businesses i've ever encountered need additional capital to grow and we want our companies to grow or they may use it to buy companies we hope that's not their most frequent use of cash because typically that goes wrong but there is some of that as well but that free cash flow yield whether it's used to acquire things whether it's used to invest further in the company or whether we receive it back in dividends that's ours that's what we own and when i'm investing your money i compare that free cash flow yield with a number of things but my sort of bottom line yardstick on it is and i choose my words carefully is i look at the free cash flow yield on our companies and i compare it with what i think the long bond yields should be in any currency and uh the keywords in that sentence are should be not what it is and because if you look at the long bond yield you'll find it's depending on which developed market you choose somewhere between two and three percent um but it's a course at that level because across the developed world governments have spent their time for the last couple of years buying their own bonds by so-called quantitative easing or printing money and funnily enough when they buy their own bonds they don't pay a very high price in terms of coupon because clearly one of the things they want to do is to drive down their cost of borrowing by this activity one of the things that they want to do with it and so they're basically arguing with themselves about what the yield should be on those bonds and as a great man once said uh you really an argument that a man has with himself really re rarely descends into a bar room brawl and so when the government's thinking of buying its own bonds it doesn't sort of say well i think i should i think the right price for these bonds is a six percent yield uh which is you know it pays this this very low rate so what should it be i work on the following basis i work on the basis that if i were a rational uh outside investor buying these bonds and by the way just as a footnote governments will eventually have to get back to selling their bonds to those people because they are running deficits they're spending more than their income what should that yield be if i were a rational outside investor my guess is i'd want a yield of at least one percent over the expected rate of inflation i want the protection of a one percent real yield for my bonds and at the moment depending upon what inflation figure you want to believe um but if you take the official ones that would probably get you to about a four or four and a half percent required yield on the bonds i would say so that's my kind of bottom line i will only buy companies therefore that have a free cash flow yield as i defined it for our companies which is about five percent or more and the reason for that is if i buy those companies with that yield that's higher than those bonds i can be sure of one thing over the long term the free cash flow yield of our companies will rise they will generate more free cash flows as time goes on from that starting price that i own them at i can be equally sure that the coupon on the bonds won't go up that's what happens with bonds they have a fixed coupon and so we have almost certainly created real fundamental value if we can buy our companies on a free cash flow yield that is higher than bonds should be yielding at this time okay um i had a look this morning and 23 of the companies that we either own or would be willing to own have a yield of more than five percent it's not as many as i would like i wish the whole lot had a yield of more than five percent frankly uh then we could buy absolutely everything that we would like to buy amongst those companies but we try and maintain the discipline of not overpaying we try and do that apart from the small fact that we're managing your money as well as our own money we're not trying to own these shares to on sell them to somebody else later on at a higher price that's not what we're trying to do here um so we can't overpay hoping that there's somebody even more foolish than us will overpay even more we're trying to buy them and just keep them and garner those cash flows over time and so with that in mind we really won't overpay or at least knowingly over pay and i'm pleased to say that we still have a significant portion of the investable universe that we would be prepared to uh to invest in and indeed are investing in so just at the moment i think the answer um is uh is that we still think that there is value available in this and and frankly um it may go further but one of the supplementaries i often get asked by people is well look these companies are very good companies i think they are um and you know i think they are provably very good companies if we're not talking about some kind of judgmental matter they produce very high returns on capital employed in cash they do it consistently they do it year in year out even at the bottom of economic cycles they can reinvest some of those wonderful returns to grow their value over time etc etc they've been established for a very long time sometimes for over a century and so on and most of them you've heard of you may even have heard of all the companies that we invest in i mean there's only about 70 so i mean it's not exactly an enormous universe so how is it that it's possible to buy these companies that are such good companies but buy them a bit cheaply how does that work and i think there are many explanations for that most of which have got to do with the concepts of economics or behavioral finance which i'll delve into very briefly because i think it's not that sort of meeting where we're going to sit here and do a hypothesis on economics but one of them is i think on average that the way that the market values companies is by a concept called mean reversion strange enough there was an article about it on the back of the financial times fund management supplement this morning by a man called edward chancellor from a fund management company called gmo and mean reversion means this if a company's got very high margins and very high returns on capital it will attract competition people will enter the industry competitors will expand the company itself will employ more capital as well and gradually those returns will be driven down towards the average for the market and if a company's got very poor returns on capital very poor margins capital will exit that strategy basically companies will exit because they can't make an adequate return companies will go bust nobody will invest in new capital and gradually the returns within that company in that industry will start to gravitate up towards the main and i think it's a very very good theory um and i think as a way of valuing companies on average i salute it i think it's the sort of thing that people should apply i think that the reason that this strategy may one of the reasons why this strategy may be viable uh what is viable and and may continue to be viable is i think there are a small group of companies in the world that don't mean revert that have superior margins and superior returns that don't get competed away and that's because they have huge intangible advantages they have brand names patents intellectual property distribution networks installed bases of equipment to which they have a tame market for selling spares and service or all of the above and as a result they're able to fend off competition so the capital can't enter their markets readily to meet revert and those are the companies that we seek to own so i think there's an economic reason for us being able to buy these companies somewhat cheaply i think there's also a behavioral reason and that is i think as investors as human beings we're attracted to incite excitement basically um if you look at investors they seem to believe and there's quite a lot of economic theory to support this that in order to make a superior return they have to take a higher risk we're taught that and there's economic theory behind it the efficient markets hypothesis there's plenty of folklore behind it there's no such thing as a free lunch you know if you want to make more money you have to take higher risk unfortunately for about the last 50 years all the statistics tell you the opposite you make most money from the most stable and least volatile shares um but still people persist in buying the small companies and the very volatile shares thinking that by assuming that risk they're going to make more money there's no sign of that whatsoever but i i think we are innately attracted to it that i think the best way of describing why we do it is the so-called lottery ticket effect you know if you buy a lottery ticket you are definitely not uh basically someone who's done it on the application of statistics because you're overpaying for the odds of the very large win but it's the very large win that attracts you and that's why i think we we are attracted towards these very apparently high return risky companies and that's what gives us our opportunity i think to buy our very good relatively predictable companies at a relatively cheap price and so yeah i often get asked about valuation probably the most amusing questions i get about valuation are from a couple of people i encounter who we talked to at the outset of fun smith or even before we set it up who uh said a couple of things uh which always amused me one of them being um well i mean your timing's really poor at the moment i mean the economic outlook is bleak you yourself are very bearish about it et cetera et cetera you know have a look at it another time that some of the same people say to me well it's only succeeded because of the good timing i mean if you hadn't started it then i i sometimes wonder if they ever sort of remember the things they previously said to you and the other one i particularly like is the people who said that i really like the strategy and what you're doing um but i do think that this is a bad time at the moment and i think when there's been a significant decline in the market i'll buy some i often think we're up about 50 today from inception if we if we started 100 and we're now trading at 50 and i said then good news we're down 50 want to put some money what do you think the outcome would be so it's wonderful i i don't think sometimes people's uh self-knowledge in terms of their behavioral characteristics in investing is very good um hopefully ours is is very slightly better uh there we are um i think i'll leave it just about there although there was one question that i was given before the meeting which uh had a certain poignancy to it because it involves somebody that both martin and i know and like very well jim slater and one of our investors said jim slater in 1970 something said the ideal investment was a can of corned beef but a gold can rather than a one made out of steel and tin and purchased on an overdraft clearly a very basic commodity but something that was gold because he didn't trust the currency in terms of what was happening at that time with high inflation inflation was 28 in 1975 in the uk worth bearing in mind and purchase with somebody else's money because with high inflation somebody else's debt is what you want to have to buy things and somebody said what's the modern equivalent i've got to thank martin for this you said the modern equivalent is a whole sweet burger wrapped in a gold etf certificate so you wouldn't actually own any gold you'd have a piece of paper from somebody telling you that they give you some good luck with that by the way if the world heads um and i'm bought with the proceeds of quantitative easing i felt very good