After reading the interview, I decided to delve just a little bit further into the answers where Mr. Yacktman discusses how he calculates the forward rate of return. Here are two select questions/answers from the above interview:
“[Question]: I have previously read some very interesting articles in which you discussed how you calculate the forward rate of return. However, I would like to ask if you could go into a bit more detail…
[Mr. Yacktman]: This number is a calculation of a normalized free cash flow yield plus real growth plus inflation. If the business is stable, this calculation is fairly straight forward. For instance, on the S&P 500 we would normalize earnings. We would then calculate what percentage of those earnings are not reinvested in the underlying businesses and are therefore free. Historically, for the S&P 500, this has been just under 50% of earnings. Currently, we expect the S&P to earn about 70 on a normalized basis, a number which is far below reported earnings due to our adjusting for record high profit margins. $70 X ½ / 1400 gives you a normalized free cash flow yield of approximately 2.5%.
The historical real growth rate of the S&P 500 is about 1.5%. Assuming an inflation rate of 2.5%, the forward rate of return on an investment in the S&P 500 is about 6.5% today (2.5% free cash flow yield plus 1.5% real growth plus 2.5% inflation). We prefer companies that have historically grown faster than the S&P 500 and can pay out 80-90% of their earnings. Today, several of our favorite companies, including Sysco, Clorox, Pepsi, and P&G meet this hurdle and trade at a discount to the market on normalized earnings. We use these types of businesses as our baseline discount rate.
Back to October of 2008, Procter & Gamble (PG) had a forward rate of return of about 9-10% while Viacom (VIA) on depressed results offered a higher free cash flow yield than our total rate of return calculation for P&G. This is not even considering growth potential for Viacom which we thought was significant from the depressed earnings level. This is an example of an easy swap that yielded huge results.
[Question]: What is the level of required return you demand for the best business today? When you normalize earnings, how do you treat and incorporate one or two years of loss a company experienced in the past?
[Mr. Yacktman]: We generally demand an annual high single-digit or low double-digit forward rate of return for a high quality business and more for one we think is lower quality. Normalizing earnings is dependent on the specifics of each company.”
Below I created a table with a rough forward rate of return for Mr. Yacktman’s 15 top holdings, but before you skip to it please read my two caveats first:
1. The table below is not “risk-adjusted.” I have not done an extensive risk analysis on each of these companies, and thus I decline to speculate as to how much risk should be factored in to each forward rate of return. That said, to help the return numbers be a little more conservative, I used the average FCF per share for the last three years in my calculations. Regardless, though, the more stable the company, the less adjustment needs to be made for risk.
(For example, P&G’s actual risk-adjusted rate of return would be much closer to the number below [11.3%] than a ConocoPhillips would be to its return figure [20%]. I want to be clear that this table is not to give a thorough, risk-adjusted rate of return for the following companies, but rather to merely give food for thought.)
2. For estimating growth I simply used conservative estimates based on past growth rates. The growth figures aren’t set in stone, and I didn’t spend hours researching estimated rates of growth, etc. Do note that the growth rates are rough estimates of real growth without inflation. They might seem lower than they should be, and that’s fine. Again, my goal isn’t to nail my growth predictions perfectly. (For all the figures I used GuruFocus’ database, sometimes using estimates due to different fiscal years for different companies.)
With those two caveats out of the way, here is a table of the forward rate of return for Mr. Yacktman’s top 15 holdings:
|Company||Portfolio Weight*||Last Price^||FCF Per Share (3-yr avg)||FCF Yield||Inflation||Growth||Rate of Return|
|2||News Corp- A||10.4%||$19.29||$1.21||6.3%||2.5%||3.5%||12.3%|
|3||Procter and Gamble||10.0%||$62.76||$4.25||6.8%||2.5%||2.0%||11.3%|
|7||Bard C R Inc||4.6%||$98.55||$6.60||6.7%||2.5%||3.5%||12.7%|
|10||Johnson & Johnson||3.4%||$62.80||$5.05||8.0%||2.5%||1.5%||12.0%|
|-||S & P 500||1,315||$35.00||2.7%||2.5%||1.5%||6.7%|
*As of 3/31/2012
^At close of trading day- 6/7/2012
Two quick thoughts:
1. 9 of the 15 stocks have a three-year average FCF yield that is higher than or equal to the expected total future return of the S&P 500. Stability and sustainability of a high-quality company’s free cash flow are thus necessarily a major factor in Mr. Yacktman’s portfolio choices. In general, growth, while a factor, is not valued as highly as stable free cash flow yield in his projection of future total return.
2. I believe that Mr. Yacktman and his colleagues are in an excellent position to surpass the returns of the S&P 500 for quite some time in the future. It’s hard to imagine a long-term scenario where these strong companies with their current rates of return and sustainable free cash flow underperform the S&P 500, especially considering that every single one of them currently has a higher rate of return than the S&P 500. (Many of them were purchased at even higher rates of return late last year and earlier this year.)
Finally, if readers have methods, ideas or other advice about calculating the forward rate-of-return, please comment! I would love to hear what you have to say.
Disclosure: Long PEP, JNJ