As I’ve written before, I’m on the fence in the active vs. passive debate. My portfolio reflects this, as roughly half of my investments are passive and the other half is in individual stocks. Within my individual stock holdings, my mindset is very much a Buffett-esque aim of owning wonderful companies at a fair price for the long term, preferably purchasing them with a good margin of safety. I use multiple objective metrics to look for that margin of safety, but I use more subjective methods to try to find “wonderful companies”.
Perhaps my favorite way to analyze whether a company, or more importantly its management, is wonderful is to look at what it does with its cash flow. If a company is growing rapidly, then retaining that cash flow to invest in more equipment, more research and development, etc., makes sense. Google and Amazon are great examples of companies that make a ton of money but have successfully (thus far) reinvested that cash back into the business to sustain a rapid growth rate without having to issue disproportionately more shares or incur unnecessary debt.
Companies that are not growing as rapidly, or at all, should have a different mindset with their cash flow. As with everyone else, they should be seeking to find the best use of that cash flow, but that best use is more likely to return it to shareholders in the form of dividends, stock buybacks or debt repayments (which frees up future cash flow no longer being used to pay interest and principal). This should be fairly logical. When interest rates are low, then don’t focus on repaying low interest debt. When stock prices are high, then don’t repurchase shares or make expensive acquisitions. When there isn’t a better use of cash, then send it to shareholders in the form of a dividend.
Yet, as I’ve mentioned before, companies tend to do just the opposite. Gilead Sciences (GILD) is the most recent example. Over the past few years, Gilead has earned a good reputation as a company that uses its cash flow appropriately between high-yielding acquisitions, a reasonable and increasing dividend, ample research and development, and timely stock repurchases. Over 10 years, Gilead’s revenue skyrocketed from 3 billion to 32 billion and its free cash flow from 1 billion to over 19 billion. At the same time Gilead reduced its share count by over 20% and initiated a dividend with a yield now over 3%.
But now its revenue is down about 7% from the prior year and its net income is down 18%, something that is close to what most analysts predicted, and something that I was okay with when I purchased the stock because of Gilead’s successful history as described above and my belief that the expected decline future cash flows were overly factored in the stock price (with a margin of safety).
What has me irked is that on the most recent conference call, management stated that it would reduce its share repurchases and that in the long term, it “may” be opportunistic with future repurchases (shouldn’t the statement be that they will “always” be opportunistic? Its like management is reserving the right to be stupid). In 2016 Gilead spent about $11 billion on repurchasing its stock at an average price of around $92/share. Yet now, with its current price closer to $65/share, it is slowing down its repurchase program? Now is the time to repurchase stock hand-over-fist, yet management is doing just the opposite. This is despite having $16.7 billion in free cash flow in the past year, which is expected to shrink approximately 7% for a year or two before evening out, and assumes that Gilead doesn’t make a shrewd acquisition or get some new drugs to market more quickly than expected. The dividend only costs about $2.5 billion per year, and that cost goes down in the aggregate as more shares are repurchased. Gilead can more than afford to maintain its share repurchases at this lower price (the same amount would buy 30%+ more shares now!) while still having ample free cash flow to make acquisitions or speed up its R&D. Not doing so sends the message that 1) management is scared that it is going to run out of cash or 2) that for some crazy reason $65/share is now too expensive for its stock whereas just a few months ago $92/share was supposedly a good enough deal to be the highest and best use of Gilead’s cash.
I’m still looking for companies that will issue stock only under the most extreme of circumstances (i.e. a tacit acknowledgement that the stock is overpriced), will only repurchase it upon the price reaching a pre-stated valuation that is a legitimate good deal (as with Berkshire Hathaway’s 1.2 times book value standard) and will return its excess cash flow to shareholders through a combination of regular, slowly growing dividends and occasional special dividends. I’ve found a few such companies, but I sure wish that list would grow…
Disclosure: Christy or I currently own Gilead (regrettably). I do not have plans to change our position in the next 48 hours. I am certainly not being paid by Gilead to write this article.