Shareholder yield must be supported by growing free cash flow


Commercial airliners have advanced autopilot systems that fly the plane for most of its time off the ground. But most planes still need a pilot for takeoffs, landings, flying through extreme turbulence and for directing and monitoring the autopilot system throughout the flight.

Similarly, shareholder yield-oriented portfolios can be managed with very low turnover because the underlying investments tend to be mature, well-established companies, and the focus of the portfolio is to capture dividends, share buybacks and debt repayments rather than trying to trade around short-term price movements. But the shareholder-yield investor cannot simply “set it and forget it.”

Remember, not all shareholder yield is created equal. Investors need to keep a few things in mind when assembling a portfolio of companies that place a priority on regularly paying their owners.

To begin with, shareholder yield must be supported by growing free cash flow. At Epoch, we expect to see free cash flow growing by at least 3 percent annually before making an investment for one of our shareholder yield-oriented strategies.

To be confident that a company is steadily growing its free cash flow, investors should ensure that the sources of cash are reliable and easily understood. Being held hostage to the outcome of a big drug trial or the next quarter’s trading revenue does not instill confidence. But things like strong brands, diversified markets and favorable demographic trends do.

Shareholder yield that is paid without the support of growing free cash flow cannot be sustained. Liquidating a business is not a long-term strategy. Another pitfall is that low interest rates have tempted many companies to fund dividends and buybacks with debt. There are instances where this can make financial sense, but adding leverage adds to financial risk. The motives of company management need to be assessed carefully when debt markets are tapped to fund shareholder yield payments.

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Along those lines, some yield-oriented strategies focus on buying stocks with high dividend yields. But again, the emphasis should be on dividend sustainability and growth. A high dividend yield can be a red flag in that regard. For example, many dividend-oriented funds had substantial investments in the financials sector in 2007 as we headed into the Global Financial Crisis. Fund managers were attracted by a strong stream of dividends from that sector despite the opacity concealing how cash was being generated.

Furthermore, a high dividend yield may be the result of a company under stress (with the yield rising as the stock price drops) or a dividend payout ratio that is too high, leaving little capital to invest for growth. A good shareholder yield strategy does not equate to a high-dividend strategy. It should invest in companies with attractive and growing dividends, along with share buybacks and debt reduction, all underpinned by growing cash flow. Some of that cash flow we would expect to be invested to ensure ongoing growth as part of a thoughtful capital allocation process.

Even sectors thought of as stable sources of dividends, such as utilities, cannot be purchased as a whole without taking on unwanted risks. That sector is indeed a good place to look for companies with alluring shareholder yield characteristics; many have prices set by regulators for long periods, stable demand, predictable cash flows and shareholder-friendly managements. But many other companies in the sector do not share these characteristics. And like any other sector, utilities can go bankrupt, with Pacific Gas & Electric being a famous example. Assembling a shareholder yield portfolio is truly a stock-by-stock exercise.

Finally, a shareholder-yield portfolio needs diversification. We tend to think of diversification in terms of sectors or countries, but we should also think of diversification in terms of cash flow growth and sources of shareholder yield. If the portfolio owns a security that has been vetted in terms of sustainability and that security has a very high level of yield, it would be tempting to make that holding among the largest in the portfolio.

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