You Cannot Grow an Acre

Right now, there are nine companies in the S&P 500 with market capitalizations over one trillion dollars: NVDA, AAPL, GOOGL, MSFT, AMZN, AVGO, TSLA, META, and MU. (SpaceX has not been added to the index.) These nine trade for 32 times earnings and throw off a 1.5 percent free-cash-flow yield on enterprise value. (All free-cash-flow figures here are net of stock-based compensation.)

We were wondering whether you could hide from this overvaluation elsewhere in the S&P index. The first, obvious thought would be to skip the top nine and own the other 491. They trade for 27 times earnings and throw off 2.6 percent on the same basis. Cheaper, but still expensive.

So we looked at various ways of slicing up SPY. We screened out every company with meaningful stock-based compensation, on the theory that the companies paying employees in stock also have the most overvalued shares. (This line of thought actually gave us a good Apple entry point in April 2024.) The low-SBC survivors yielded 2.1 percent, worse than the index, because the screen mostly caught the bid-up defensive complex: utilities, staples, telecom, the names people own for safety. We tried another screen, keeping only the companies that have shrunk their share count over the past five years. That group was the best of the lot at 3.2 percent, but it is not a number worth writing home about.

Put the four cuts together and the ladder of free-cash-flow yields runs from 1.5 to 3.2 percent of enterprise value. None of them are "cheap." Unfortunately, the 491 are not a bargain hiding behind the nine. They are slightly lower-quality businesses, on average, at a quality-adjusted price that is roughly the same. There is no secret cheap slice in the index, because the index as a whole is pretty expensive on the cash that actually reaches an owner.

One option would be to sit in cash and bonds and wait. If the correction doesn't come in a year, you'll be rooting for the world to end. Also, the U.S. federal debt to GDP and the deficit are both high enough that the government will be sorely tempted to inflate its way out, and a government that wants inflation usually gets it. In that world, cash and bonds hand you a negative real return after tax. 

That is the box. Stocks are expensive, but bonds are expensive too. We need a "third way."

There are two ways for a good business to slip through the cracks and be excluded from the passive, indexation bid. One is structure: a master limited partnership or other pass-through cannot go into the index, because the funds that track it cannot hold those companies without tax problems. The other is size: a company too small to move the index gets no meaningful flows. Either way the price is set by people doing valuation arithmetic rather than by a machine that has to buy. These have been called "orphaned securities."

Take Enterprise Products Partners. EPD is a partnership, so the index cannot own it, trades for 11x ttm EBITDA, which allows a 5.9% dividend that is largely tax deferred to be well covered. That is several times the owner yield of the index, for a toll road whose revenue is largely contracted. The standard objection is obsolescence: pipelines are a melting ice cube in an electrifying world. But a large share of EPD's business is natural gas liquids and petrochemical feedstock, and petrochemicals are a secularly growing market, not a shrinking one. Demand for plastics and chemicals rises with population and income whether or not anyone buys another gallon of gasoline. The terminal-value fear is priced as if the whole franchise rides on crude oil. It does not.

Or take a land base. Rayonier (RYN) owns timberland and trades below what the dirt would fetch in the private market. It is a real-estate trust, so in theory it could be indexed, but it is far too small ($6 billion market cap) for the popular indices. Natural Resource Partners owns mineral and royalty land and is orphaned twice over, a partnership and tiny (only $1.3 billion market cap). Neither one has factories to run or fashions to chase. They own real assets that throw off cash, with no large operating or capital budget to eat into the return. In a world where the currency is being diluted, a perpetual claim on an acre or a ton is exactly the thing to own. 

Something falls out of this search that we did not go looking for. The orphans are close to the perfect assets for a great inflation. In many cases they are inflation-protected bonds wearing equity clothing, and  the index-ignored corner of the market is not where you would expect to find them.

It is not a coincidence. A land or royalty asset returns its cash because there is nothing to reinvest in. You cannot grow an acre. That single fact is why it is the right thing to own in an inflation: a real claim paying a real coupon, with no plant or equipment whose replacement cost keeps climbing. And it is the same fact that orphans it. Cash that has nowhere to compound has no reason to sit inside a corporation paying the double tax, so the asset is wrapped in a partnership. An asset that never reinvests never swells into something the index notices, so it stays small. Return your cash and you are orphaned twice, by structure and by size.

So the index runs an inadvertent filter. It bids up the businesses that retain and reinvest, which is most of what is expensive, and it leaves alone the ones that pay everything out, which is where the yield is. That is the bargain. You collect a real yield on the assets best built for the world the deficits are inviting, and you collect it precisely because the largest pool of money in the market is forbidden to bid against you. The only thing asked of you is the willingness to buy what no one is forced to buy, and to hold it on the days when no one is forced to buy it back.