Hendershot Investments is a quarterly newsletter focused on conservative, high-quality (or HI-quality, for Hendershot Investments) companies for the long-term investor, many of which pay dividends. Editor Ingrid Hendershot wrote the following essay on the importance of free cash flow (or FCF) in the March, 2012, issue:
“Seeking to build an investment stash, folks need to decide how to invest their hard-earned cash. There are three broad-based investment categories for investors to consider: fixed-income investments, such as bonds, CDs or U.S. Treasuries; commodities, such as gold; and stocks.
“In Berkshire Hathaway’s annual letter to shareholders, Warren Buffett cautions investors about investing in fixed-income investments and gold. He says, ‘Right now bonds should come with a warning label,’ as inflation erodes current low interest rates, resulting in negative real returns. Gold bullion, of course, provides no income, and Buffett thinks fear over an economic collapse has driven gold prices to bubbly heights. Not surprisingly, Buffett believes stocks will outperform both bonds and gold, explaining, ‘Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety — but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.’
“We also believe HI-quality businesses, generating strong free cash flows, will prove to be winning investments for long-term investors. We define free cash flow as the cash flow a business generates from its operations less the capital expenditures needed to maintain and grow the business. Free cash flow per share divided by a stock’s price generates a free cash flow yield, which may be compared to alternative investments. … Firms with strong free cash flows can invest in internal growth programs, fund acquisitions and provide consistent, value-creating returns to shareholders through growing cash dividends and share repurchases at attractive valuations. By following the cash a company generates, investors may determine if management is allocating the capital in shareholder-friendly ways.
“For example, cash-rich technology companies like Cisco (CSCO) and Microsoft (MSFT) return excess cash to shareholders, with Cisco repurchasing nearly $74 billion of its stock and Microsoft paying $64 billion in dividends since the inception of each program.
“On the other hand, Apple (AAPL), which is generating a whopping $41 billion in free cash flow on a trailing 12-month basis, does not currently pay a dividend or repurchase shares. Instead, Apple’s cash has been piling up on the balance sheet. With nearly $100 billion in cash, Apple may soon shake the apple tree and share the cash with shareholders through a seedling dividend payment. [Editor’s note: It did.]
“Other firms using strong cash flows to steadily increase dividends include Emerson (EMR), which has boosted its dividend for 55 years, and Abbott (ABT) which has increased its dividend for 40 consecutive years. Express Scripts (ESRX) has used its growing cash flows to fund acquisitions and repurchase substantial amounts of its stock. Accenture (CAN), Baxter International (BAX) and Western Union (WU) all pay dividends but also place an emphasis on share repurchases.
“With HI-quality stocks sporting free cash flow yields significantly higher than low-yielding bonds, investors should follow the cash to build an investment stash!”