After volatility spiked at the end of 2018, investors were reminded that portfolios need ballast during challenging market environments – this is especially the case for portfolios seeking post-retirement income.

In the book, Free Cash Flow and Shareholder Yield: New Priorities for the Global Investor, authors William Priest and Lindsay McClelland outline a compelling case to consider the true drivers of business—and therefore shareholders—returns. They say the key to understanding a company and the return on investment it will provide requires a focus on the cash generation drivers of the business – rather than a focus on traditional accounting terms like earnings or book value.

Indeed, an analysis undertaken by Priest and Epoch Investment Partners of the S&P 500 Index over the 90 years between 1927 to 2017 found that the average annualised return was 10 per cent. Over rolling 10-year periods, price-to-earnings (PE) ratios made up 0.9 per cent of that return, while earnings and dividends made up 5.2 per cent and 3.9 per cent respectively.

This means that, despite the focus of many in the industry on PE ratios and other accounting metrics, the bulk of investment returns come from dividends and earnings, and dividends and earnings come from one place: cash flow.

The question of how the business generates its free cash flow—along with how its management allocates that cash for the betterment of the shareholders—is an important one to understand in the search for investment opportunities providing income.

After all, it is the ability to generate free cash flow that makes a business worth anything to begin with. And it is the ability of management to allocate that cash flow properly that ultimately determines whether the value of the business rises or falls.

Key considerations

Epoch Investment Partners says there are essentially only five ways that business management can allocate a company’s free cash flow. They are:

  1. pay a cash dividend
  2. buy back stock
  3. pay down debt
  4. make an acquisition, or
  5. invest in internal projects.

From here, the analysis is simple. If a company can invest, either internally or in an acquisition, and generate a marginal return on invested capital that is greater than its marginal cost of capital, then making that investment will increase the value of the business.

But if the return is going to be less than the cost of capital, making the investment will reduce the value of the business.

In this case, a better strategy would be for management to return the capital to the shareholders instead (through one of the methods listed above).

The shortcomings of traditional investment metrics

Accrual-based accounting measures such as earnings, and valuation metrics based on earnings, simply do not provide the relevant information as to whether a company is successfully generating free cash flow and whether management is skilled at allocating that cash flow properly. An additional consideration for those investors seeking income is that various accounting metrics to measure earnings can be distorted by accruals, and can be easily manipulated.

Earnings are an opinion, cash is a fact, and if this holds true, a company’s real value should be measured on the free cash flow that it generates.

Most income seeking investors would consider the holy grail of portfolio asset allocation to be that which generates a sustainable and growing yield from their investments, without a high degree of volatility, enabling the portfolio to both support their investment objectives and increase in value over time.

There is no doubt that, as interest rates have fallen, income-seeking investors have bid up the value of stocks with high dividend yields. Their focus, however, is all too often on a high absolute level of yield, and blindly chasing dividends is a poor strategy. Not all dividend-paying companies are worthy investments.

A better approach is to focus on a sustainable and growing yield. And while some high-yielding stocks look expensive, there are still many reasonably priced companies globally, where growing free cash flows and maintaining conservative payout ratios are standard practice.

There are of course Australian companies producing substantial shareholder yield in the form of dividends, share repurchase and debt reduction, and some of them representing good value. However, it would be difficult to construct a properly diversified portfolio from Australian companies alone – to do so risks sacrificing the expectation for shareholder yield and accepting a higher level of portfolio volatility.

A global mandate, in contrast, provides investors with the most robust set of stocks from which to choose. The focus needs to be on companies which return a proportion of their market capitalisation to shareholders on a regular basis, while still reinvesting enough in the business to grow operating cash flow. Invest in these companies, globally, and you’ll find good returns.