Identifying stocks with durable cash flows is key for investors seeking stability and consistent shareholder value. In this clip from "The Rank" on Motley Fool Live, recorded on June 13, Motley Fool contributor Tyler Crowe explains why A.O. Smith (AOS -1.05%) makes sense as a strong pick during a high inflationary environment.
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Tyler Crowe: A.O. Smith is the nation's largest manufacturer of commercial boilers, water heaters. They also do some water purification, air purification systems. But they own about 40% of the residential and commercial water heater market. As they guessed, I also picked O'Reilly (ORLY 0.03%). I specifically picked both A.O. Smith and O'Reilly with the idea that we may be in a period of higher inflation, reduced consumer spending. I'm not saying it's happening, but in the event that these things happen, I wanted to look for not just cash flows, but incredibly durable cash flows cycle. Here's the thing that is important about residential water heaters. You hear that and you think like, oh, construction. If they start building houses, we're screwed. That's not necessarily the case because between 80% and 85% of all purchases of water heaters in the United States, residential at least, are replacements of existing systems. You're not going without hot water. Show of hands. Anybody here like when their hot water heater blows and they got to get a new one. Are you like, "No, I'll put that off for three weeks to a month."
Jason Hall: When it happens, you pay whatever it costs as quickly as you can get it done.
Crowe: Exactly. That right there goes to show the durable cash flows that you get from A.O. Smith. There's a little bit of an upside and downside with construction, but we're always talking about 15% of the North American market for them, which is their cash cow. They have a little bit of exposure to China. It's been one of their fastest-growing segments, and has been a good investment for them so far. Their prior CEO, Ajita Rajendra took over, I believe, as CEO. He was the COO in 2011, and took over as CEO in 2013. He's been the big engine over the past one decade or so. Turning a fledgling water heater company into the giant that it is today. In terms of generating just free cash flow and being incredibly shareholder-friendly. Rajendra was the person who really started to go with the overseas. They started attacking the Chinese market. They're getting into the Indian market. Middle income areas where rising incomes are leading to demand for hot water on-demand. I might be a little apprehensive to the China exposure, I don't want to lean into it really hard in my investment thesis just because on the very outside chance something does happen. I'm not saying it is, but just in case. But just looking at that simple replacement systems in North America, there's such a durable cash cow that they have the ability to pay their dividend. It's not great right now. I think it's just under 2%. They've been buying back stock and it's been an incredible shareholder wealth generator for quite some time.
Hall: This is not PayPal (PYPL 0.64%), buying back stock to cover stock price.
Crowe: No.
Hall: Reducing the share count significantly, buying back stock.
Crowe: They've been able to translate mid-single-digit revenue growth into double-digit earnings-per-share growth for quite some time. The last couple of dividend raises have been in the 20% range. There's a lot of shareholder value being created here.
