Shareholder yield must be supported by growing free cash flow

  • Some yield-oriented strategies focus on buying stocks with high dividend yields. But the emphasis should be on dividend sustainability and growth.
  • A shareholder yield portfolio needs diversification in terms of sectors or countries but also in terms of cash-flow growth and sources of shareholder yield.
The shareholder-yield investor cannot simply "set it and forget it."
Stephan Hoeck | Getty Images
The shareholder-yield investor cannot simply "set it and forget it."

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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But to reap the full benefits of diversification, that holding should be limited in size so that it does not represent too large a percentage of the portfolio's overall yield. That may seem counterintuitive at first, but diversifying in this fashion ensures that the shareholder yield being harvested in the portfolio is not dependent on one or two high yielding stocks.

This approach to diversification can help investors take a collection of stocks that already have lower-than-average risk profiles and further reduce their volatility as a group. And aiming for less volatility is increasingly on the minds of investors as risks to financial markets gather.

Here are some examples of stocks that will play well when it comes to shareholder yield and that we recommend to investors:

BCE

Dividend yield: 4.9 percent (as of 9/30/2017)

Bell Canada Enterprises is Canada's largest communication company, with more than 21 million customers. Its three main business lines are wireline, wireless and media. Cash flows are driven by a combination of pricing and increasing penetration of its cable triple play product, wireless customer base/LTE adoption and ad content-driven TV and radio stations.

Capital expenditures on its network and spectrum are kept in check by its network sharing agreement with Telus. Its main use of cash is investing in its wireless network and growing its fiber footprint. BCE has a consistent and growing divided that is favorably covered by a 65 percent to 75 percent free cash flow payout ratio. The dividend should grow in the mid-single digits in line with cash flow growth. Excess cash generation will go toward reducing the debt incurred from acquisitions and spectrum purchases.

"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."

Texas Instruments

Dividend yield: 2.2 percent (as of 9/30/2017)

Texas Instruments is one of the world's largest semiconductor manufacturers. With an 18 percent share, it is the largest analog manufacturer and is the industry leader in technological innovation. While not a pure play analog company, the company generates 62 percent of sales and is the largest participant in the market, capturing 18 percent of the $44 billion industry. It is also a large player in the embedded products market.

Top line and free cash flow is expected to grow at double that of gross domestic product, driven by underlying industry growth and continued market share gains. Capital expenditures are roughly 4 percent of sales, which is adequate to continue to generate solid growth, aided by their large size relative to their competitors. Its stated model is to generate 20 percent to 30 percent of top-line revenues in free cash flow, and payout 100 percent of free cash flow to shareholders through its increasing dividend, share repurchases and targeted debt reduction.

— By Kera Van Valen, portfolio manager at Epoch Investment Partners

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