Procrastinators Can Still Join the Party in This Stock

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

One of the best strategies for part-time investors is to track successful hedge fund managers' holdings and pick which stocks look the most promising. Investors who followed Bill Ackman into Procter & Gamble (NYSE: PG) have already reaped large gains -- the stock is up nearly 33% since the legendary investor announced his hedge fund owned 1% of shares outstanding.

However, despite the run-up in the stock price over the last year, Ackman has maintained his position in the company. The stock is less appealing than it was when it traded in the low-$60s per share, but it may still trade below intrinsic value.

Pricing power

Like many companies that own well-known brands, Procter & Gamble benefits from tremendous pricing power. Its brands are usually the best-known in their respective categories -- Charmin, Gillette, and Pampers, to name a few. 25 of its brands gross over one billion dollars annually -- more billion-dollar brands than any other company in the world.

Procter & Gamble's brand recognition enables it to lead or dominate many of the markets in which it competes. Market leadership makes it imperative for retailers to carry the company's products and give them prime shelf placement, making it more difficult for competitors to sell their products. This allows Procter & Gamble to earn ample and predictable free cash flow.

The chart below is illustrative of Procter & Gamble's pricing power. Over the years, the company has earned high and relatively stable free cash flow margins similar to that of Colgate-Palmolive (NYSE: CL) and higher than that of Unilever (NYSE: UN).



Colgate-Palmolive and Unilever are just about the only companies that come close to matching Procter & Gamble's consumer products brand portfolio. Despite being a much smaller company based on overall sales, Colgate-Palmolive completely dominates its product markets; the company's Colgate brand represents nearly half of all toothpaste sales, far outpacing Procter & Gamble's Crest toothpaste brand.

Unilever, on the other hand, earns lower free cash flow margins than the other two companies because its packaged food segment earns lower margins than its consumer products division. However, the scale of the company's international distribution network, combined with strong brands (including Hellmann's mayonnaise and Lipton teas), enable it to earn consistent margins year after year.

The key about each of these companies is that they earn stable free cash flow margins. Except in exceptional years, the companies' free cash flow margins oscillate between one to two percentage points of the long-term average. This indicates that each company has a high degree of control over its margins, suggesting a high degree of pricing power.

Investment case

Since each firm earns a consistent free cash flow margin, we can calculate no-growth free cash flow by applying each firm's 10-year average free cash flow margin to trailing twelve months sales. Doing so gives us no-growth yields between 4% to 5% for all three companies.

However, each company will likely grow at least as quickly as the United States economy -- and probably a little faster due to operations in emerging markets. As a result, a long-term growth rate of 2% to 3% is a reasonable estimate for these wide-moat companies.

Therefore, investors who buy Procter & Gamble, Colgate-Palmolive, and Unilever at current prices will likely receive a 6% to 8% compound annual return on investment over a five-year holding period. Not bad for entrenched companies in an overheated market.

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Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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