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High Conviction in High Quality Stocks

By

Nathan Kawaguchi

IgnoreTheMarket.com

What should investors do when faced with ultra-low interest rates and a risky global business outlook? No matter what the circumstances and outlook, investors should always look for the best risk-adjusted returns with acceptable risk parameters. Currently, long-term investors can find that in high quality stocks.

As of today, the five-year and ten-year U.S. Treasuries yield 1.80% and 3.00%, respectively. The investment grade corporate bond index yields 4.80% and the high yield corporate bond index yields 8.90%. Now, let's take a look at free cash flow yields for a sample of ten high quality stocks (Note: depending on how one adjusts for free cash flow, calculations may vary).

Kimberly-Clark (KMB) 7%

AutoZone (AZO) 8%

IBM (IBM) 9%

Liberty Global (LBTYA) 9%

Omnicom (OMC) 8%

Viacom (VIA-B) 8%

Wal-Mart (WMT) 8%

Quest Diagnostics (DGX) 9%

Johnson & Johnson (JNJ) 8%

Walgreen (WAG) 10%

Let's assume that this basket of high quality global leaders has an average free cash flow yield of 8%. Stocks can be viewed as variable coupon, perpetual junior bonds. Compare their average yield of 8% to a 3% "risk-free" ten-year U.S. Treasury, a 5% investment grade corporate bond, and a 9% high yield corporate bond. Even assuming zero growth over the next 10+ years, the basket of high quality stocks is still the most attractive on a risk-adjusted basis.

It doesn't make a lot of sense to buy high yield bonds of financially weak businesses at a 9% yield when high quality businesses are yielding 8% with stronger fundamentals and opportunities for growth. And the spread of free cash flow yields over Treasuries and investment grade corporate bonds is at levels that compensate investors for the risk of owning businesses in uncertain times. And keep in mind that these free cash flow yields are based upon recession-impacted 2009 results. Many of these businesses have experienced growth in 2010.

The other reason why high quality stocks are so attractive at these levels is that if the global economy really does remain weak for an extended period, investors should only expect these global leaders to become stronger. This is because most of these companies have durable competitive advantages and have access to lower cost capital than many of their competitors.

These stocks are not intended to be recommendations and investors should always do their own research before investing. They are merely a sample of stocks meant to reflect current opportunities being offered by Mr. Market. There is great uncertainty over the next five to ten years, but investors with long time horizons should be rewarded for their patience in high quality stocks.

Disclosure: Long IBM & WMT and have recently recommended KMB, AZO, IBM, LBTYA, OMC, WMT, DGX and WAG at IgnoreTheMarket.com.

About the author:

Nathan Kawaguchi
Nathan Kawaguchi is a Research Analyst for IgnoreTheMarket.com. IgnoreTheMarket.com provides independent, value-based stock and mutual fund research, a blog, and acts as a hub for value investing information and research. Nathan Kawaguchi is a former stock broker and has over 10 years of experience analyzing securities.

Visit Nathan Kawaguchi's Website


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