As dividend cuts make headlines, it is important to remember that dividend payouts are only the tip of the iceberg when it comes to identifying dividend-paying companies and sizing up dividend risk relative to a company’s total return3 potential. Moreover, in the current environment of rising dividend yields, it’s important to be cautious about “yield chasing”, as some of these yield premiums could be due to precipitous stock price declines instead of bona fide, sustainable growth in the underlying businesses.
Consistent dividends and dividend growth are characteristics of good businesses, but in the view of the management team of the PH&N Dividend Income Fund, other more important factors must be evaluated in tandem. These include strong free cash flow, a solid financial position, and a management team with a record of making intelligent decisions regarding how it deploys free cash.
In an era when corporate earnings can easily be obfuscated by the rotating door of GAAP methodologies4, it is refreshing to be able to rely on a valuation metric that is difficult to manipulate or misrepresent. Free cash flow is one such measure, and it is attractive for its transparency.
Free cash flow is the cash that is left over after a company has made the appropriate allocations to maintain or grow its asset base (working capital and capital expenditures). Essentially, this pool of “free cash” allows a company to pursue shareholder-friendly activities, such as paying dividends, making acquisitions, and paying down outstanding debt.
The chart below was adapted from research conducted by Empirical Research Partners – it depicts relative returns for U.S. large cap stocks sorted by dividend growth, share repurchases, and price/free cash flow over the 35-year period from 1970-2005.
You will notice the following:
- Strategies focused only on dividend growth have only modestly outperformed the S&P 500 Index.
- Companies that pay no dividends at all have the worst return records.
- Strategies focused on price/free cash flow were the most effective at outperforming the S&P 500 Index.
Even in today’s severely compromised market environment, companies are fiercely protective of their free cash flow. Despite the downturn, free cash flow has held up remarkably well due to a couple of factors: a low capital expenditure base and aggressive management of working capital.
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