In a global equity shareholder yield strategy, there are only five possible uses of corporate cash: reinvestment, acquisitions, dividends, share repurchases and debt pay downs. Reinvestments and acquisitions should be pursued if the firm expects a return higher than its cost of capital.

Otherwise, the best use of cash is to provide shareholder yield. All three forms of shareholder yield — dividends, share buybacks and debt repayments — are effective forms of returning wealth to shareholders. Each adds more or less value at different points in an economic cycle.

According to the Financial Times (12 April 2015), US companies are on course to return US$1 trillion to shareholders in 2015. That’s nearly as large as Australia’s superannuation pool! The article states that more than US$903 billion was returned to investors in 2014 – US$350 billion in dividends and US$553 billion in share buybacks.

The focus of part 2 of this article series is on share buybacks. It seems all the big corporates are doing it, and not just in the United States.

Apple. In its fourth quarter 2014, Apple spent US$17 billion buying back its stock, taking its total spend on share buybacks for 2014 to US$45 billion. This comes on top of more than US$30billion buyback program in 2013.

Nestle. In August 2014, Nestle SA, the world’s largest food company, announced that it planned to spend 8 billion Swiss francs (US$8.8 billion) in its first share buyback in three years after reporting revenue growth that exceeded analysts’ estimates.

Rio Tinto. On 7 April 2015, Rio Tinto announced the successful completion of its off-market buyback program, which was increased to A$560 million from the original A$500 million announced, due to strong demand.

Is it all good news?

Share buybacks have been receiving a lot of attention and press, much of it critical. We read that:

1. Even though corporate profits are high, companies are not investing, but are buying back their common stock instead,
2. Companies are issuing debt to fund share buybacks,
3. Managements are using share repurchases as a tool to inflate EPS and achieve compensation-related targets, and
4. Companies are notoriously bad at timing share repurchases, buying when flush with cash and share prices are high.

In the context of a global equity shareholder yield strategy, share buybacks are an important component of a company’s shareholder-value-maximising capital allocation process; share buybacks are simply one of the ways that a company can return excess cash flow to shareholders.

Whether that shareholder distribution takes the form of a cash dividend or a share repurchase program does not matter, although the value to shareholders of a cash dividend is obvious and tangible, while the value of a share repurchase is not quite as straightforward.

However, consider the following simple example: If you were one of ten partners who owned a business, and it was (mutually) decided to use free cash flow to buy out the interests of two partners, the remaining eight partners would end up each owning 1/8 of the business instead of 1/10.  Note: there has been no diminution of the business enterprise value because you did not sell off an asset to raise the cash to fund the repurchase of interests, you used free cash flow and nothing has happened to impair that collection of assets from generating future cash flows.

Good buybacks and bad buybacks

There are companies that add leverage – and therefore risk – to finance share buyback programs, and there may be management teams who are more interested in lining their own pockets than creating value for the owners of the business.  The important thing is to weed out the “bad” share buybacks from the “good” through careful and thorough analysis of each company.

As managers of a global equity shareholder yield strategy, Epoch Investment Partners emphasise the importance of analysis to ensure the management has considered share buybacks in the context of other strategies. Has the company’s management successfully identified high-return investment opportunities that enhance the value of the firm? Has the cash flow that has been returned to owners, in fact, been the highest and best use of that cash, or is their focus on short-term, self-enriching manipulation of EPS.

Epoch cites the 2014 share repurchase program of Herbalife, financed with debt and accompanied by the termination of the quarterly dividend, as an example of a share buyback program that failed to meet the definition of ‘value-enhancing’.

Return on capital vs. return of capital

In Epoch’s opinion, the related criticism that share repurchases frequently do not generate an attractive return on capital is based on a fundamental misconception. Studies have attempted to evaluate cash used to repurchase shares in the same way that cash is used to make a capital investment. While this seems to make some sense, it fails to distinguish between a return on capital and a return of capital.

When a company uses cash to, say, build a new manufacturing facility, it is appropriate and desirable to evaluate the return that the company earns on this capital investment. But, when a company uses free cash flow to retire shares, it is not somehow buying its own shares and holding them as an investment, hopefully earning a profit on its position. It is returning capital to the owners of the business.

A share of stock is evidence of an ownership interest; when the shares are repurchased and retired, the ownership interest is extinguished.

It is equally illogical to assert that stock price appreciation subsequent to a share repurchase program is evidence that the shares were undervalued at the time of the buyback and therefore management has succeeded with a value-enhancing repurchase, or that the failure of shares to appreciate following a buyback is proof that the share buyback was a mistake and not value-creative.

The best way to think about share buybacks, in Epoch’s view, is not that they will lead to subsequent share price appreciation, but that at the time of the repurchase, returning cash to the owners was simply the next best use of cash at that point in time.

A global equity shareholder yield strategy looks to invest in businesses that have proven themselves to be good capital allocators by investing free cash flow to fund high-return growth opportunities and by returning value to shareholders in the form of cash dividends and share repurchases.

The philosophy underpinning a global equity shareholder yield strategy sees dividends and share repurchases as equivalent ways of returning excess free cash flow to the owners of a business – in other words, to investors. As a result of such strategies, global equities can generate a reasonable level of income for investors.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the views of Grant Samuel Funds Management (GSFM) and sources believed by GSFM to be reliable. We do not represent that this information is accurate and com­plete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither GSFM, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. Past performance is not a reliable indicator of future performance. Investing involves risk including loss of capital invested. ©2015 Grant Samuel Fund Services Limited.

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The most recent interest rate move in Australia was downward and there is expectation of further cuts in the coming months. While this is great news for those paying off a mortgage, it can spell hardship for retirees reliant on interest income from cash accounts or traditional defensive investments.

Global equities for income?

Global equities generally aren’t top of mind when it comes to investing for income. Consider:

Despite this seemingly low average yield (albeit higher than the current cash rates in the US and UK), equity dividends can be an attractive complement to other forms of income. By focusing on a global equity dividend yield strategy, investors can access a wider opportunity set to capture more dividend-paying companies and higher yields.

What is global equity shareholder yield?

A global shareholder yield strategy is underpinned by the fundamental principle that a business – any business, in any industry and in any geography – has exactly five possible uses of free cash flow (defined as those funds available for distribution to shareholders after all planned capital spending and all cash taxes) to preserve the existing cash-flow-generating capacity of its current collection of assets. The five uses are:

1. Invest in organic growth projects that deliver a return on capital above the firm’s weighted average cost of capital.
2. Invest in strategic mergers and acquisitions that deliver a return on capital above the firm’s weighted average cost of capital.
3. Pay cash dividends to shareholders.
4. Retire debt obligations.
5. Repurchase shares.

From this perspective, a company that has free cash flow left over after funding all internal and external projects that meet return on invested capital (ROIC) hurdles has a fiduciary obligation to return that excess free cash flow to the owners of the business – the shareholders.

This two-part article will focus on two key components of shareholder yield – dividends (part 1) and share buybacks (part 2).

Are dividends enough?

Dividends are back in fashion, with the virtues of dividend payers increasingly highlighted by the financial press. Over long periods, companies that pay dividends have outperformed those that do not. And, as illustrated in figure 2, they did so with considerably less volatility.

Figure 2: Company dividend strategies and effect on risk and return

Considered a sign of corporate health, dividends typically reflect the ability of a company to make money with some consistency. Dividends also indicate that management is attentive to shareholders and confident in the prospects for the business.

However, investors need to understand how the dividend is being paid and where it fits within the capital allocation policy. Otherwise, the blind pursuit of dividends for their own sake can be financially hazardous.

Investors need to know where dividends come from. Are they getting a return on their capital, or a return of their capital?

The only way to be sure is to learn how much free cash a company generates. The next, and more difficult, step is to gain confidence that cash can be produced with transparency and consistency. Another readily seen example of a pitfall for dividend strategies is the emphasis on financials prior to the Global Financial Crisis in 2008.

Investors searching for dividend yields in a low-yield environment were attracted to equities. At the end of 2007 the US financial sector had a dividend yield of 3.4% compared to a dividend yield of 2.0% for the entire S&P 500 Index. Similarly, global financials had a dividend yield of 3.6% compared to a dividend yield of 2.4% for the entire MSCI World Index (source: Epoch Investment Partners). These yields attracted equity investors and caused them to overlook the lack of transparency in how cash was generated.

Investors also need to consider if a dividend is the best use of cash. Effective CEOs and CFOs weigh the benefits of returning cash to shareholders against internal reinvestments and potential acquisitions as part of a capital allocation strategy.

If projected returns for reinvestment or acquisitions exceed the firm’s cost of capital, then they should make those investments. If they do not, then excess free cash flow should be returned to shareholders.

To sum it up, there are only five possible uses of corporate cash: reinvestment, acquisitions, dividends, share repurchases and debt pay downs. Reinvestments and acquisitions should be pursued if the firm expects a return higher than its cost of capital.

Otherwise, the best use of cash is to provide shareholder yield. All three forms of shareholder yield — dividends, share buybacks and debt repayments — are effective forms of returning wealth to shareholders. Each adds more or less value at different points in an economic cycle.

Adopting a broad view by taking all three into consideration can be more rewarding than only focusing on one. Companies that provide shareholder yield, as a result of growing free cash flow and intelligent capital allocation, should outperform over most of the economic cycle.

The following video features the pioneer of the global equity shareholder yield strategy, a unique strategy that can enable investors to derive an above average yield from global equity investments. Bill Priest is the CEO, co-CIO and a Portfolio Manager with Epoch Investment Partners, and author of Free Cash Flow and Shareholder Yield: New Priorities for the Global Investor, which details the underpinnings of a global equity shareholder yield investment strategy. His colleague Eric Sappenfield, Managing Director and Portfolio Manager, also discusses the strategy.

http://www.eipny.com/index.php/S=0/epoch_insights/videos/highlights/shareholder_yield

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DISCLAIMER:  The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the views of Grant Samuel Funds Management (GSFM) and sources believed by GSFM to be reliable. We do not represent that this information is accurate and com­plete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions.  All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither GSFM, its related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. Past performance is not a reliable indicator of future performance. Investing involves risk including loss of capital invested. ©2015 Grant Samuel Fund Services Limited.

The post Investing for income – can global equities deliver? (Part 1) appeared first on AdviserVoice.

Romina Graiver

Recently in Australia to promote William Blair’s Unit Trusts, launched earlier this year, William Blair’s International and Global Equity Specialist, Romina Graiver, said the Chicago-based asset manager uncovers many quality opportunities in emerging markets.

“Investors know about the growth story in emerging markets however we believe in many cases they underestimate the quality aspect of it,” she said. “Sustained high level of economic growth has enabled many emerging markets companies to generate consistently higher returns on assets and capital. We also acknowledge that some areas and macro events have provided a tailwind effect for companies to do better as they benefit from an economy that is growing, rather than contracting, which is where we are seeing that there is a bit of de-coupling.”

Finding high quality growth companies in emerging markets is Chicago-based global asset manager William Blair’s driving theme with approximately a third of their 2500 global quality growth investment universe made up of emerging markets companies.

Ms Graiver said some emerging markets companies within William Blair’s Emerging Leaders strategy also belong to the Global Leaders strategy, which demonstrates that these companies can be among the highest quality on a global scope.  “We use the same process, research and analysis for companies in both portfolios but it is tougher for an emerging market company to get into the Global Leaders strategy because of the broader opportunity set,” Ms Gravier said.

“William Blair looks at the top down views, but at the end of the day, we use bottom up fundamental analysis to find quality growth companies with strong governance. We are not going to play a theme if we are not finding the best quality growth companies in that theme,” Ms Graiver said. “In emerging markets we like countries where we see tailwinds for companies to do even better, for example countries where we see opportunities for reform, rather than countries where the macro trends are a headwind for companies.”

“We like India and Indonesia for instance,” Ms Graiver said.  “In India we increased our exposure well before the elections. India is a market where we often find very high quality companies with very strong management – like IT services and pharmaceuticals. Early this year we increased our exposure to more cyclical names, which are expected to benefit from an improvement in the domestic economy. We also like auto-related companies in India, some of which are benefiting from car demand recovery and improved sentiment.”

Ms Graiver said William Blair saw a real growth opportunity for India with the likelihood of the Modi pro-growth government coming to power, which would provide a better framework for these quality companies.

“We looked at Modi’s previous work as a provincial Governor and how this boosted GDP growth and in his work fighting corruption and bureaucracy along with feedback from companies who had different activities in different regions.  The standard of living in Modi’s Gunjarat province was much higher than other regions of India.”

William Blair has increased exposure slightly in Indonesia, Ms Graiver said, where there are some high quality companies and again there is likelihood for reform with a new government. William Blair has also increased to an overweight position in Mexico due to the clear intention for structural change and also the benefits of proximity to the United States as a trading partner.

Ms Graiver said in contrast to the above, Brazil, which is struggling with slow growth, high inflation and a current account deficit, does not look compelling from a top down perspective. There are, however, some very attractive  companies with strong operating performance and growth prospects. “Despite the weak macro environment, some companies are benefiting from secular growth drivers, such as evolving consumption patterns driven by social demographic changes; others are supported by government policies  like in  the education space” Ms Graiver said.

In China, William Blair is underweight, however, less than before. Ms Graiver said William Blair sees some optimism regarding recent data reports, helped by mini or targeted stimulus measures however, they see a long term deceleration of economic activity. “China is going through a big deleveraging process which will reduce GDP growth,” she said.  “The government seems committed to reform and is moving forward in many areas (financial reform, SOEs, etc) but at the same time they have to manage the gradual transition from high-leveraged and investment driven economy to a more consumer driven economy. There may be some pain along the way however there are areas in China that are seeing favourable growth trends and the market is attractive from a valuation perspective compared to other markets and compared to its own history.”

In the end it is William Blair’s ability to select quality stories in their universe of emerging markets which benefit from the tailwind of prospects and growth at a macro level which is an additional driver of performance.

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Observations on the Responsible Investment Sector

While it was a fairly unremarkable year in terms of product development, there were a number of significant team movements impacting on the sector. ‘Offerings from AMP Capital, Australian Ethical and Challenger all experienced significant personnel change,’ said Steve Sweeney, Lonsec’s Senior Investment Analyst responsible for reviewing the sector.

The lack of new entrants highlights the Responsible Investment sector’s continuing adjustment to subdued post credit crunch appetite for equity products. “There are a few exceptions (e.g. emerging market funds) but generally this trend is consistent with product development across most equities categories as fund managers continue to consolidate product lines,” said Sweeney.

Sweeney also attributes the lack of new Responsible Investment product development in some part to the failure of last year’s UN Climate Change Summit in Copenhagen to produce a meaningful outcome on achieving global emission reduction targets.

“Responsible Investment proponents were hopeful that a positive agreement committing economies to material emissions reduction would significantly progress the climate change agenda boosting the sector with some positive regulatory developments for key industries and companies,” said Sweeney.

Despite the lack of product growth, Lonsec observed an increased integration of ESG (assessment of environment, social and governance practices) into the mainstream company research process.

Sweeney noted that this trend has not been exclusive to funds in the traditional ethical or SRI sector but across other sectors including Australian equities, global equities, Asian and emerging market funds.

Although this trend is blurring the lines between the Responsible Investment sector and mainstream equity funds, Sweeney commented that there still remains “considerable grounds of distinction between ethical and sustainable or ESG style funds, including philosophical approach, that are likely of material interest to investors in these funds”.

Lonsec noted that while the sector’s Australian equity peer universe is modest (7 funds) there has been a wide variance in performance for the past 12 months and that this highlights that it is not a ‘one size fits all’ investment approach.

‘It’s important to recognise the structure of these funds can have a significant performance impact either through restricting the investment universe (e.g. no exposure to resources) or introducing increased volatility compared to mainstream large cap Australian equity funds due to greater exposure to smaller companies” said Sweeney.

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