SMSF trustees wanting capital growth and low volatility should look no further than cash flow strategies, writes Damien McIntyre.
A paradigm shift is taking place in the sources of return for investors in global equity markets. So says William Priest, chief executive officer of New York-based Epoch Investment Partners. It is a shift that Australian investors – who have traditionally focused on Australian equities with their tax-paid dividends – cannot afford to ignore.
In his book Free Cash Flow and Shareholder Yield: New Priorities for the Global Investor (co-written with Lindsay McClelland and published by John Wiley & Sons), Priest argues the current investment landscape is among the most dynamic and complex in the history of the capital markets.
Today’s investor must contend with dramatic alternatives to the traditional methods of stock selection and portfolio construction as the order of the drivers of total equity returns are realigned, and the irreversible effects of globalisation take hold.
Added to these powerful forces is the presence of a flat-to-rising interest rate scenario following decades of declining interest rates.
Paradigm shift
There are three determinants of equity returns: how much money a company makes, how much it gives back to shareholders, and the price investors are willing to pay for those elements. The most common measures of these three determinants are earnings, dividends, and price-to-earnings (P/Es) ratios.
These factors have varied in importance during different time periods. During the bull market of the 1980s and 1990s, the expansion of P/E multiples was the driving force behind global equity returns.
Expanding P/E multiples also were largely responsible for strong returns in 2012 and 2013 as central banks provided unprecedented monetary accommodation in the form of quantitative easing and the European Central Bank in particular reassured investors that it would do “whatever it takes” to preserve the euro.
Over time, however, the expansion and contraction of P/Es has been neutral for stocks, and P/Es are unlikely to be a significant contributor to returns in the coming years.
P/Es are correlated with interest rates. The expansion of P/Es in recent decades was underpinned by a collapse in interest rates.
Today, interest rates across most of the developed world are near historic lows and are more likely to rise than fall. In the US, rates have already begun to rise, with the Federal Reserve reducing its quantitative easing by “tapering” its purchases of Treasury bonds.
If P/Es no longer have the support of falling interest rates, they will have limited scope to rise from their current levels. That means an increasing proportion of return is going to come from dividends and earnings. Both come from free cash flow.
Cash is king
Priest argues the key to producing superior risk-adjusted returns in such an environment is to understand how companies generate and allocate free cash flow, rather than depending on traditional accounting measures such as earnings or book value.
(Free cash flow is defined as the cash available for shareholders, after expenses, planned capital expenditures and taxes).
Earnings, book value and other accounting concepts are dependent on assumptions and accruals, such as depreciation. These are often best guesses that can obscure reality. Adding to that, accounting rules often change and the increasing use of pro-forma reporting renders accounting less meaningful in comparing one company to another.
Free cash flow, however, is a more honest and transparent measure of a company’s moneymaking ability than earnings, which are easily distorted.
The focus should be on companies that are generating free cash flow and are run by management teams committed to deploying that free cash flow for the benefit of shareholders. There are only five uses of cash:
- Acquisitions
- Reinvestment through internal projects
- Cash dividends
- Share buybacks
- Debt reduction
The first two applications of free cash flow represent the ways a firm can reinvest for growth. The last three are all forms of returning capital to shareholders (see Chart 1).
Reinvesting cash flows in internal projects or acquisitions is preferred when those actions will generate returns above the cost of capital.
Otherwise, company managements should return excess cash to shareholders through dividends, share buybacks or debt repayments – collectively known as “shareholder yield.”
Investors should learn everything they can about a company’s free cash flow: its source, its transparency, its growth rate, its volatility and its optimum applications given the firm’s cost of capital.
A strategy for the future
Successful investment managers will put this theory into practice. Using fundamental research, they will seek companies that can grow free cash flow and allocate it intelligently for the benefit of shareholders.
In Epoch’s case, the strategy involves companies that emphasise shareholder yield.
This entails identifying companies that return approximately 6 per cent of their market capitalisation to shareholders, on a per annum basis, in the form of cash dividends, share buybacks and debt reductions.
These companies must also possess an annual underlying growth rate of free cash flow of at least 3 per cent.
These distributions are characterised as shareholder yield in that they represent capital returned to shareholders, Priest says.
While many investors focus on cash dividends, repurchasing shares and paying down debt are also a form of returning capital; both provide shareholders with a larger claim on a company’s free cash flow.
In the current environment, funds that take an approach such as this will become increasingly attractive to investors, particularly self-managed superannuation fund trustees and their advisers, who desire capital growth with substantial income as an investment objective.
This approach offers lower volatility than most equity products and will distribute higher levels of income.
It is likely that the investing habits of SMSF investors will shift, and indeed we are already seeing evidence of this.
Traditionally it has been Australian equities – with the benefit of their tax-paid franked dividends – rather than global equities that have been in the sights of SMSFs.
However, as SMSF trustees become more sophisticated and educated, they are looking further afield.
Equally, as baby boomers shift from accumulation to retirement strategies, more fund managers will be looking to post retirement investment solutions. In this environment investors, more than ever before, will be seeking above-average income with lower volatility.
As we continue to face the realities of the new millennium, this strategy offers the best chance for successfully navigating the global investment landscape.
Historical perspective
Chart 2 breaks down equity returns into three components: earnings, dividends, and price-to-earnings ratios. Over time, the relative importance of these three components has changed dramatically in response to changes in the economic landscape.
In the 1980s and 1990s, for example, rising price-to-earnings ratios were the principal drivers of equity returns, leading to the popularity of valuation methodologies that reflected price-to-earnings and price-to-book metrics. Underlying this 20-year PE expansion was a collapse in interest rates.
Now we have entered a period in which price-to-earnings ratios have limited scope to expand. They have already risen from depressed levels following the global financial crisis and the European sovereign debt crisis – and interest rates are not far from their all-time lows and are more likely to rise than fall over the coming decade.
Given the inverse relationship of price-to-earnings ratios to interest rates, the expansion of earnings multiples will no longer be the primary explanatory variable of equity returns.
This leaves earnings growth and dividends – the two variables that have been the dominant components of equity returns over the past 80 years. These two variables are derived from a single source: cash flow.
Damien McIntyre is head of distribution at Grant Samuel Funds Management.
Originally published by SMSF Essentials.
