• Avoiding yield traps.
In a similar vein, investors selecting income-generating equities frequently place far too much emphasis on current dividend yield. High yield is often a trap that reflects the market’s well-founded scepticism about the advertised income stream.
Yield alone should never define an income stock, and there is a very real trade-off between yield on the one hand and sustainable growth on the other.
Often-favoured investments have relatively modest initial yields, but this is combined with a demonstrable capacity to sustain and grow their distributions to shareholders.
Such growth produces a fast-growing cash income stream, which, when held for sufficient time, can outstrip the higher initial yield offered by static companies.
• Emphasising free cash flow.
Sustainable dividends are funded from excess cash flows.
Some fund managers therefore search for companies with an ability to grow free cash flow and maintain this over a very long period of time.
We consider growing free cash flow to be the long-term source of equity value creation and what funds a dividend. Accumulating debt to pay dividends is not sustainable and eats into equity value.
Businesses that can consistently grow while earning attractive returns on invested capital will naturally generate an abundance of free cash flow.
In order to do this, they must have a clear runway for growth and possess assets – powerful brands or high switching costs, for example – that enable sustainably high returns to be earned. A growing free cash flow stream provides tremendous flexibility for companies.
They can either reinvest for further growth, distribute cash back to investors, pay down debt or simply accumulate cash for later use.
By contrast, low-returning businesses with limited growth prospects will always struggle to grow free cash flow, and therefore equity value or income.
The latter group of companies is best avoided, irrespective of the advertised dividend yield, in favour of free cash flow growers.
The long-term opportunity
Given the extraordinarily low interest rate environment, it has seldom been more important for investors to consider the trade-off between sustainable growth and yield.
In our view, the appropriate yield at any point in time is the one that results from investing in those businesses capable of growing their free cash flow and dividend over the long term.
Reassuringly, in spite of the impression that the weighted index can give, we find ample opportunity for such investments in the UK.
Blake Hutchins is a senior fund manager at Troy Asset Management
