A Tale of 2 Stocks

This article is part of our Rising Star Portfolios Series.

Yesterday, I introduced you to a sleepy yet awesome firm called Landauer (NYSE: LDR  ) , a specialist in radiation monitoring and analysis for labs, hospitals, and nuclear facilities worldwide. Since 1990, the stock price has quietly gone up five times in value, with its success based on a niche market, fragmented competition, and a diverse customer base. It still retains these attributes, yet I've passed on it for my portfolio. I'll explain why and then I'll show you another investment I like better.

It's all about the price
Investing is all about evaluating a business and deciding what price to pay. The price you pay impacts the returns you will ultimately realize from a stock, and at the wrong price, even the greatest company could make a poor investment. Landauer is a very good company, but it's simply too expensive.

For slow growth industries, it's best to think about the investment in terms of what sort of return you're getting -- similar to a bond. This should ideally be done with a free cash flow yield, but an earnings yield (inverse of the P/E ratio) can also be used. In Landauer's case, its earnings yield is 4% (a P/E of 25). This doesn't look appealing when safer Treasury notes yield almost 3%, but we have to remember that Landauer can probably grow earnings at about 5% per year.

However, while compounding is a big plus, it only gets really powerful with high rates of growth -- say 10% or more. At 5% growth, your hypothetical 4% coupon from Landauer only gets bumped up to 6.2% by year 10.

So in a pretty good scenario for slow-growing Landauer, an investment would yield only 6.2% on your original cost basis in a decade. Contrast this with one of my favorite stocks today: L-3 Communications (NYSE: LLL  ) . L-3's free cash flow yield is about 10%. Even if that yield doesn't grow over the next 10 years, by the end of that time, you'll still be getting 10% per year out of L-3, higher than Landauer. In fact, it would take Landauer 20 years to match the return you can get from L-3 on Day 1, and this gives L-3 a much better internal rate of return: 8% for L-3 versus 2% for Landauer.

Take a look at the following numbers

Year 0 1 2 3 5 10 15 20 Internal Rate of Return
Landauer Payments        $(100)  $4.0         $4.2         $4.4         $4.9 $6.2         $7.9         $10.1    2%                         
L-3 Payments $(100)  $10          $10          $10          $10          $10          $10          $10          8%

Source: Motley Fool calculations.
Payments = initial investment and annual net income.

Of course, this is a very simple analysis with a few caveats. Landauer generates a higher return on capital and pays out most of its earnings in dividends while L-3 prefers a combination of dividends and share repurchases, both impacting the ultimate return investors receive. Another one is that I've stopped in year 20. The longer the growth continues for Landauer, the more it closes the gap on L-3. However, even after 20 years, L-3 is still way ahead in terms of the internal rate of return, and a good 20-year run with no hiccups for Landauer is a pretty generous forecast and perhaps less certain than no growth from L-3. So I'm happier earning a better return up front than waiting for it to come in the mail perhaps 20 years from now.

Take the money and run
These are both fine companies, but there are two takeaways: (1) your earnings yield is important, and (2) zero-growth companies can be great investments. L-3 hasn't made it into my Rising Star portfolio just yet, but it has a very good shot. As for Landauer, I love the company but am sitting tight for a more rewarding price.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Andrew Sullivan, CFA, owns call options on L-3 Communications. The Fool owns shares of L-3 Communications. 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.


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