Although the hedge fund industry attracts the best and the brightest, few fund managers are considered to be a “genius.” I think Baupost’s Seth Klarman deserves such accolades, and people like Warren Buffett and George Soros are inarguably brilliant. But the smartest manager in the business may be one that many have never heard of.
I’m talking about Jim Simons.
According to a recent glowing profile in the New York Times Simons:
-- Received his doctorate at 23;
-- Advanced code breaking for the National Security Agency at 26;
-- Led a university math department at 30;
-- Won geometry’s top prize at 37;
-- And founded Renaissance Technologies, one of the world’s most successful hedge funds, at 44.
At Renaissance, Simons has built a strong long-term track record, by deploying a massive amount of computing power to identify winning picks, known in the field as “quant investing.”
Based on his recent stock buys, we have a pretty clear sense of what Simons’ models are telling him now. In the second quarter of 2014, his firm spent a combined $435 million to establish new positions in three companies that, at first glance, have nothing in common. One is in energy, another makes consumer staples and the other is in retail. Their common trait: they all generate prodigious amounts of free cash flow.
Free cash flow (FCF) is the main bottom-line metric you should track with regard to mature companies. Other metrics have their faults: net income can be manipulated by accounting gimmicks, and operating income can hide the fact that capital spending eats up all the true profits. Instead, FCF is a direct measure of how much cash can be deposited on the balance sheet.
If you’ve been focusing on companies with impressive buybacks or dividends lately, then you have witnessed the power of FCF.
Interestingly, all of these companies are going through a sort of mid-life crisis and must seek ways to re-invent themselves. Jim Simons knows that such firms have a considerable arsenal of weapons to help rejuvenate the business, meaning their current challenges are quite fixable.
Here’s a closer look.
1. ExxonMobil (NYSE:XOM)
This oil titan faces the same challenges as its peers: the world is awash in oil and gas, but newer energy fields are becoming more expensive to tap into.
In the chart above, you can see that FCF fell sharply in 2013, thanks to a series of one-time expenses related to global drilling programs. Management has spent the past 4-6 quarters optimizing operations, selling off assets in certain areas while pouring heavy investments into others.
The net result: FCF is about to rebound—in a big way. Analysts at Merrill Lynch see FCF rising to $17 billion this year, to $25.5 billion next year and to $29.3 billion in 2016.
Investors have a clear sense of what XOM will be doing with all that money. XOM bought back nearly two billion shares since 2005, which has helped to boost per share profits. Meanwhile, XOM’s dividend has been boosted at a double-digit pace for the third straight year.
2. Procter & Gamble (NYSE:PG)
This consumer goods giant has been in a rut.
Sales have been stuck in the $80 to $85 billion range for four straight years, and analysts expect more of the same to be reported in fiscal 2015. With 160 distinct brands under its management, the company has been deemed too unfocused. Notably, the top 70 brands account for more than 90% of sales.
P&G understands that it’s time to shake things up. Management recently announced plans to sell 90-100 non-core brands, yielding more than $10 billion in annual savings. This can set the stage for P&G to re-invest in product categories that have better growth potential.
“We think this shows P&G is breaking ties with its former self, looking to become a more nimble and responsive player in the global consumer products arena,” wrote Erin Lash, an analyst at Morningstar. “Even a slimmed-down version of the leading global household and personal care firm will still carry significant clout with retailers.”
If management doesn’t use the proceeds to acquire new brands, they can place greater emphasis on dividends and buybacks. From fiscal 2008 through fiscal 2014, P&G was able to shrink its share count by 400 million to 2.9 billion shares. In fiscal 2014 alone,
P&G spent $6 billion on buybacks and another $6.9 billion on dividends. P&G’s current dividend yield of 3.2% is impressive, but pales in comparison to the impressive fact that the dividend has been boosted for 58 straight years.
The company’s move to shake up the portfolio and free up cash likely means that the winning streak will stay intact for a while to come.
3. Bed, Bath & Beyond (Nasdaq:BBBY)
Jim Simons isn’t alone in his ardor for this domestic goods retailer. A few months ago, I noted that other funds were building positions in Bed, Bath & Beyond after a precipitous plunge in the stock. Simons, like many savvy investors, knows that the best time to focus on such stable companies is when they are out of favor, as Bed, Bath & Beyond surely is right now.
As I noted then, FCF is slated to fall this year as management steps up investments in the website and store base, which should set the stage for renewed FCF growth in coming years. If you are wondering what BBBY will do when FCF rebounds, you need only look to the past: The company’s share count has already shrunk from 300 million in 2005 to around 200 million today, and that figure is likely heading yet lower in coming years.
Risks to Consider: These three companies are all in the midst of a challenging year. They lack imminent catalysts and should be seen as long-term investments.
Action to Take --> Robust free cash flow can help a stock play defense when the market action gets rough. Investors often make a flight to safety at such times, focusing on companies with defensible moats and rain-or-shine cash generation. All three of these businesses have proven themselves over the long haul and should be capable of robust free cash flow growth in coming years.
A healthy, growing dividend and stock buybacks are signs of a strong company. Those are two of the three metrics my colleague uses to calculate a stock's "Total Yield." By analyzing this trinity, my colleague Nathan Slaughter found a group of the most stable, profitable companies on Earth -- these stocks outperformed the S&P 500 during the "dot-com" bubble and the 2008 financial crisis. To find out more about Total Yield stocks, click here.