Generally speaking, higher interest rates are bad for growth stocks because profits for many high-flying growth stocks are way off into the future. A higher discount rate makes those future cash flows worth less in the present. As the 10-year treasury has risen from a low of 0.51% in August 2020 to over 1.50% today, the intrinsic value of many of these growth stocks has been impaired or reduced. This could cause the long-expected rotation from growth stocks to value stocks in the coming years.
On a relative and absolute basis, I firmly believe value stocks such as AT&T (NYSE:T) and International Business Machines (NYSE:IBM) will outperform high flying growth stocks such as the FANG group over the next 3-5 years.
With that in mind, here’s a bit more on why these two seemingly boring ideas could turn into relative winners in the coming years.
Why AT&T Stock Looks Attractive Today
AT&T has morphed into a diversified telecom and media company in recent years. The acquisition of DirecTV and Time Warner created a company that Alexander Graham Bell couldn’t possibly comprehend 100 years ago. The DirecTV acquisition in 2015 was perhaps ill-timed, as it closed upon the advent of the global streaming phenomenon and subscribers have declined steadily since the acquisition. However, the satellite company provides strong free cash flow, which is important from a value stock perspective, as we will see.
The 2018 acquisition of Time Warner (now WarnerMedia), which has yet to be proven as a successful purchase, provided AT&T with industry leading brands such as HBO, CNN, Warner Bros and DC Comics. AT&T is also the largest cellphone and mobile service provider in the country with over 176.7 million subscribers.
The key advantage for AT&T is cash flow — free cash flow, to be specific. Although growth rates in most of its segments, and for the company overall, won’t be setting any records soon, the company generates a substantial amount of cash. For 2021, the company might generate $44 billion in operating cash flow and after $18 billion in net capex. That leaves over $26 billion in free cash flow to cover dividends, debt repayment and share buybacks.
The hefty dividend alone will cost about $15 billion (that currently yields approximately 7%), which leaves $11 billion for debt repayment. That is why most analysts aren’t worried too much about AT&T’s heavy debt load. Every dollar of debt repayment should accrete to equity shareholder value over time.
IBM Stock Offers Growth Opportunities at Low Valuations
Describing the history of IBM would take more space than this column allows, but today, the company provides a diverse collection of hybrid cloud, technology infrastructure and consulting related products and services.
The legacy operations of managed infrastructure services and related consulting will soon be spun-off into a separate company. The remaining core business will be largely driven by the revenue growth for Red Hat, which IBM acquired for $34 billion in 2019. This segment will likely rely on additional acquisitions, particularly in the cloud space.
The spinoff is expected to have much lower growth rates, but it will likely pay a higher dividend. The combined dividend of the two new companies is not expected to be less than the current pre-split dividend, according to IBM. Currently, the dividend yield is 5.5%, with a forward payout ratio close to 50%. The separation is expected to occur by the end of 2021. The company continues to spend about 8% of revenues on Research & Development, with spending last year amounting to $6.3 billion.
Although the payoffs from much of these investments are years or decades away, IBM is known for its innovative leadership in quantum computing, artificial intelligence and blockchain technology.
These Value Stocks Belong On Your Radar
AT&T trades at 9.3x 2021 estimated cash earnings and 5.5x EBITDA, while IBM stock trades at 10.8x 2021 estimated earnings and 7.0x EBITDA. The strong free cash flow from both companies will be recognized in coming years as investor see that cash is king and rapid growth doesn’t always win the day.
At the risk of being called an old windbag, with these low valuations and high dividend yields, these two value stocks are likely to outperform high-flying FANG stocks over the next 3 to 5 years.
On the date of publication Tom Kerr did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Kerr, CFA is an experienced investment manager and business writer who has worked in the investment and securities business since 1994.
