By James Knoedler (pictured), co-manager of the TB Evenlode Global Equity Fund
In a period of lofty valuations, the classic debate about ‘how much is too much’ is in full spate. Investors fear a choice between Scylla – overpaying for growth – and Charybdis – buying value traps. In this context, cautionary tales are again being invoked from the ‘Nifty Fifty’ of the 70s to the dot.com bust.
While the current environment is arguably not exactly fertile for finding value in quality names, our intention is always to buy the best businesses available at a reasonable price, rather than buy reasonable businesses at the best prices available. Our process is, in our understanding, fairly differentiated, being based on a systematic analysis of lifetime cashflow available to equity investors in a company.
Evenlode has traditionally been an income investor, with a commitment to returning a certain level of income through dividends to its investors. This heritage means any fund we run is dividend aware, even if the strategy does not have an income mandate. We are keenly conscious dividends are the way equity holders ultimately get paid in cash directly for their holdings, excluding liquidations of companies.
Raw materials of shareholder return
All stock sales are essentially upfront capitalisation of rights to future dividends. The dividend yield of a listed company is a critical piece of information for any prospective investor, but experience has shown dividend yields are poor guides to the right valuation for a company.
Any valuation discipline must contend with the challenge of mature companies which have exhausted their capital deployment opportunities. Lacking reinvestment opportunities, they often have exceptional cashflow generation, and consequently often pay out a very high percentage of free cashflow as dividend.
There is also a perpetual temptation for management teams to pull forward earnings and set capital return too high, in order to trigger gains in their incentive packages. These insights drove our focus on lifetime dividends, which automatically eliminated companies where our analysis of company fundamentals and industry structure suggested dividends were unsustainable.
We believe the best indicator for lifetime dividend payout is lifetime free cashflow generation, as this is the raw material for shareholder returns. If we can identify companies with the best ratio of lifetime cashflow to current market capitalisation and enterprise value (EV), the thesis runs, we can construct differentiated portfolios with attractive outcomes for investors.
Our expectation is that internal cashflow compounding in our portfolio companies will over time yield higher actual dividends. This will be the engine of value creation for our portfolios. On the other hand, we do not expect mean reversion of company valuation based on spot metrics to be a meaningful driver of investor returns.
We turn to discounted cashflow (DCF) models in order to optimise our portfolio exposure to this compounding. These models have the attractive aspect of considering lifetime cashflows rather than the earnings one year forward of a company, which drive traditional price to earnings (PER) and free cashflow yield (FCFY) metrics.