Why Shareholder Yield?
Hi, I'm Kera Van Valen, Portfolio Manager for the Shareholder Yield Strategies. We are often asked why Shareholder Yield and why is it relevant today? To answer those questions, we'll start with a little history. The drivers of equity market returns can essentially be broken into three components – dividends, earnings and PE ratios.
Looking at the S&P 500 over long periods of time, we see the PE ratios expand and contract, ultimately contributing very little to total return. This means the bulk of the return comes from dividends and earnings, which are derived from cash flow.
In creating the strategy, we felt we could identify a number of companies who were more likely to return the bulk of their cash flow to owners of the business. We set out to build a portfolio with certain characteristics – a cash yield of roughly 4.5%. 1.5% from share buybacks and debt reduction, and at least 3% from cash flow growth.
When looking at the evolution of the shareholder yield portfolios, it's important to note the consistency with which we have captured the current yield, the additional yield from share buybacks and debt reduction, and the underlying growth rate that supports the yield.
How do you construct your portfolios?
So how do we build this portfolio? At TD Epoch, we focus on free cash flow when evaluating companies. We feel that it's very important to think more like a CFO would think. How does the company generate their cash flow and how do they allocate the cash back to shareholders?
This is different than some other managers that focus more on accounting-based metrics, where you're talking about price to earnings or price to book. We feel those can be more easily manipulated, and that it's very important to focus on exactly how a company generates their cash and how they allocate that cash to determine the true value of the company.
If you think about it, there are really five things a company can do with their cash. You can reinvest in the business or make acquisitions. And by all means, if you can earn above your cost of capital, that is what you should be doing to grow the value of your company. However, we do not feel there's an unlimited supply of opportunities to do so, and in those cases, you should be disciplined about returning the cash to shareholders through either dividends, share buybacks or debt reduction.
We consider those three uses of cash shareholder yield. They are all forms of dividends in that you're returning the cash to the shareholders of the business.
The cash flow growth mentioned earlier is what allows us to have confidence in the sustainability of the cash returns year after year. As a result of the type of companies that we invest in and the portfolio construction process, we do typically end up with lower volatility than the overall market. This does make sense if you think about it. Dividends are always positive contributors to equity market returns.
Our process starts with a proprietary quantitative screen that helps us identify companies that are capable of generating sustainable free cash flow.
Part of what we're looking for within our screen is companies that pay attractive current dividends today. We don't want to hope and dream that a dividend is going to materialize in the future. We want to see that those dividends are coming from a reoccurring source of cash. That's what helps with the sustainability of the dividends and that the cash flows are growing at the company.
We also want to see that there's a commitment from management to consistently returning cash to shareholders through dividends. So, we look to see that the companies have not canceled their dividend in the long-term history of the company, nor have they reduced the dividend too many times. And we certainly don't want to see a dividend reduction in the more recent years.
The screen helps us identify companies that are capable of generating sustainable free cash flow, we then, as fundamental analysts, look at the companies to decide whether we think those cash flows are sustainable in the future. We want to look at how a company generates their cash flow and how that capital is allocated. Is it a revenue growth story? Is it a cost cutting story? Is there room for working capital improvements? Where is the company within its CapEx cycle? We really want to understand what's driving the free cash flow and then, how committed management is to returning the cash to shareholders through that combination of dividends, share buybacks and debt reduction.
We build out models looking back 3 to 5 years, looking forward 2 to 3 years. We really want to understand the safety of that cash return back to shareholders.
Why is Shareholder Yield attractive now?
Getting back to the question of why now, we think the current attraction has to do with the lower volatility that we mentioned. Equities have endured dynamic and often unpredicted market conditions recently while navigating a landscape defined by tariff uncertainties, volatile interest rates and geopolitical shocks. Longer term structural shifts taking place, such as deglobalization and the realignment of supply chains, add further to the complexity of the environment.
We believe that a dividend focused equity strategy is ideally suited to maintaining equity exposure, while managing risk more deliberately. This is because dividend payers tend towards steadier returns, less speculative valuations and heightened resilience through challenging and uncertain market environments. In fact, companies who consistently pay dividend, and especially those who grow their dividends, are empirically proven to possess lower standard deviations than those who do not.
In conclusion…
Our shareholder yield strategy has historically offered broad diversification across sectors and geographies, lower than market volatility, attractive dividend income, and significant downside protection when equities come under pressure. The strategy emphasizes high quality businesses with sustainable and growing levels of free cash flow, prudent capital discipline and a focus on delivering shareholder value through the combination of dividends, share buybacks and debt reduction.
The strategy has historically outperformed when volatility is present. Return has been primarily generated through downside protection during declines and maintained through strong upside participation during rallies. Smaller drawdowns mean less ground to make up when markets rebound. Looking beyond present uncertainty, maintaining a lower volatility in an equity allocation can lead to a smoother return profile and enhance wealth creation in the long run.
With the way forward so clouded by macro uncertainty and lingering catalysts for further volatility. The wide array of possible outcomes is something that investors should be considering while managing risk exposures and positioning for years to come.
We believe that the shareholder yield strategy is poised to capture the productivity of the growing economy while remaining defensively positioned for resiliency to begin to falter.
Thank you.
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