Growing free cash flow: the key to sustainable equity shareholder yield

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 equity portfolios can be managed with very low turnover and relatively little trading because the underlying investments tend to be mature, well-established companies. Moreover, the managers of these portfolios seek to capture dividends, share buybacks, and debt repayments­­­­­—the three key sources of shareholder yield—rather than trying to trade around short-term price movements. However, the shareholder yield investor can’t simply set it and forget it and expect stable dividend payments to continue in perpetuity.

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 through shareholder yield.

To begin with, sustainable shareholder yield must be supported by growing free cash flow—cash remaining after a business spends the money required to maintain or expand its asset base. At Epoch, we expect to see free cash flow growing by at least 3% annually before making an investment for one of our shareholder yield-oriented strategies. In the United States, the ranks of companies meeting this criterion are likely to expand, as the recently approved overhaul of U.S. tax law has reduced the corporate income-tax rate from 35% to 21%, enhancing cash flows.

To be confident that a company is steadily growing its free cash flow, investors should ensure that the sources of a company’s cash flow are reliable and easily understood. To cite an example from the pharmaceutical industry, a company whose cash flow prospects hinge on the outcome of a big drug trial doesn’t instill confidence. Similarly, a financial stock’s reliance on the next quarter’s trading revenue could prove to be speculative. In contrast, enduring strengths such as strong brands, diversified markets, and favorable demographic trends offer greater potential for generating consistent growth of free cash flow.

Shareholder yield that’s paid without the support of growing free cash flow can’t be sustained; liquidating a business isn’t a long-term strategy. Similarly, the environment of low interest rates that we’ve experienced in recent years has tempted many companies to fund dividends and buybacks with debt. There are instances in which this can make financial sense, but adding leverage adds to financial risk. When a company taps debt markets to fund shareholder yield payments, the motives of the company’s management need to be assessed carefully.

Along those lines, some yield-oriented strategies focus on buying stocks with high dividend yields. Again, the emphasis should be on dividend sustainability and growth; a high dividend yield can be a red flag in that regard. For example, in 2007, prior to the global financial crisis, many dividend-oriented funds had substantial investments in the financials sector. Fund managers were attracted by a strong stream of dividends from that sector, despite the opacity that concealed 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's too high, leaving little capital to invest for growth. A good shareholder yield strategy doesn’t equate to a high dividend strategy; it should be about investing in companies with attractive and growing dividends, along with share buybacks and debt reduction, all underpinned by growing cash flow. We'd expect some of that cash flow to be invested to ensure a company’s ongoing growth as part of a thoughtful capital allocation process.

Even sectors that are often regarded as stable sources of dividends, such as utilities, can’t be purchased as a whole without taking on unwanted risks. The utilities sector is indeed a good place to look for companies with alluring shareholder yield characteristics. For example, the rates of many electric utilities are set by regulators for long periods, and many of these utilities possess durable strengths such as stable demand, predictable cash flows, and shareholder-friendly management teams. But many other companies in the sector don’t 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. Many investors 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 a portfolio’s holdings include a stock that's 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.

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

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

Learn more about investing in U.S. equities here.