The collapse of the technology bubble shows that when it comes to stockpicking, cashflow is the best way of measuring a company's real value, regardless of how much growth potential that company may have
I should admit up front to being a strong believer in cashflow as a fundamental basis for equity investment of all kinds, not just equity income funds. I have believed this for many years and so what I say is not intended in any way as a criticism of other investment styles.
I do not believe any unique style of investment works to the exclusion of others ' different styles can work very successfully for different people. Cashflow works for me, however, and I will try to explain my thinking and why I believe cashflow is a sustainable and repeatable approach to successfully picking stocks in almost every stock market environment.
One major stock market period has clearly occurred, namely the recent technology bubble, when no conventional valuation-based approach worked for stock market investing. I believe this stock market period was a once-in-a-career event when fundamentals counted for little. The shares that went up typically had no profits and often no turnover, but rather a blue-sky vision based on an unproven business model about how they would capture a large share of a yet undeveloped market.
During the period, growth investing was hugely successful in that as long as you followed the correct theme you were bound to make money. Given that many companies had no turnover or profits, they could not be blown off course by profit warnings since they did not make any profits. Also, since all the value was typically expected in 10 years and beyond, no one could use current trading as an argument for ultimate success or failure for that company.
Strong technical factors were also at work, as Vodafone issued unprecedented amounts of new equity to fund its global acquisition binge. Many investors were forced to buy shares at any price to cover the risk of not having any shares in what was a significant part of stock market indices and competitor funds.
The barbell approach is about marrying a mixture of low-yielding growth shares with some very high-yielding investments to make up the income requirement, possibly convertibles, shares or bonds. Cashflow investing is all about valuing profitability only when it converts to cash (profits that do not convert to cash are worthless) and holding the right shares based on their cashflow qualities and total return possibilities.
Cashflow valuation techniques can be a valuable tool for investing in growth stocks, answering the question of how quickly a company will have to grow its cashflow to justify its premium valuation. If you believe that equities will outperform bonds in the longer term, as I do, then using bond or bond proxies in an equity fund will be a drag on relative performance.
The growth, low-yielding equity proportion of the fund will have to make up for this drag on performance. The question for barbell then is whether a low-yielding portfolio of growth equities outperforms traditional yielding shares by a sufficient margin.
The best proxy for equity income shares within the UK stock market is the FTSE 350 High Yield Index (350 HY), which is essentially the higher-yielding half of the market excluding smaller companies. For 2001, the 350 HY delivered a total return of '2.2%, compared to a total return of '13.3% for the FTSE All-Share Index.
In other words, higher-yielding shares outperformed the broader stock market by a large margin ' a trend that has continued into 2002. Is this outperformance typical, or is 2001 an unusual year? The 350 HY has been calculated since 1986 and, since then, it has consistently outperformed the stock market as a whole, with the exception of the technology bubble at the end of 1999. The graph below illustrates this performance clearly.
For me, this graph is a strong support for a traditional approach to equity income investing. Although, as the graph illustrates clearly, barbell would have been an incredibly successful approach in the 1999-2000 technology, media and telecoms bubble.
However, it is worth noting how investors have lost more money in the technology fall than they made in the technology rise. I believe this loss is due to large share issues near the peak of the bubble by the likes of Vodafone after their shares had already performed very strongly.
If income investors choose the 350 HY as their benchmark, they will have a different perspective to the risk of not investing in Vodafone, whose shares have always offered a low yield and, consequently, have never been in the 350 HY. Although not part of the 350 HY, Vodafone stock is present in many competitor equity income funds, despite the fact that it pays little dividend. I have taken the view that the stock has been overvalued for a number of years and have not held it since I took over the AXA UK Equity Income Fund in 1996.
In any case, the shares offer little yield and so 350 HY benchmark risk was not apparent in this decision. Had I thought the shares were cheap, several possible convertible issues were available to gain exposure to Vodafone. Convertibles are always an option for equity income investors, although, in my experience, they have tended to be an expensive way of buying income in the last few years.
In my opinion, a large enough universe of attractive investment opportunities exists just by looking at higher-yielding shares. The art of successful investing then lies in picking the right companies within the universe. I believe in buying companies where attractive cashflows support their premium yields and are cheaply priced. Ultimately, cashflow makes a premium yield sustainable, just as internal cashflow is required for a growth company to sustain its investment needs without being dependent on external funding.
A good example of a company that has consistently looked cheap on a cashflow basis in recent years and whose shares have performed strongly is Imperial Tobacco. The shares have continued to perform strongly during the first quarter of 2002, spurred on by its recently announced acquisition of Reemtsma. Imperial Tobacco continues to benefit from strong cashflow, modest growth and a management team that is committed to delivering shareholder value, while offering a useful yield premium to the market.
Equally, investors can buy growth when it is cheap, on a yield premium and out of favour. For example, Reed International shares were depressed a couple of years ago post a dividend cut and change of senior management team. The new management team and its plans for the company impressed us; we had the opportunity to meet them early on before the added value was widely appreciated by the market.
As these plans have come to fruition, the shares have responded very positively. Although the shares were very depressed at the time of the management changes and on a yield premium despite the cut in dividend, we could see the company resuming its growth path on a two to three-year view.
As always, the skill is identifying a strong management team that will deliver. I believe investing invariably comes down to backing good management teams, timing and valuations. It is no coincidence that well-managed companies tend to have strong market positions and excellent cashflow characteristics.
Markets tend to come back to fundamentals in the end ' technical stock shortages only drive up shares when fundamentals are strong. As an income fund manager, I find it interesting that, being a patient investor, I can often buy quality companies on a yield premium when they are out of fashion or favour for some reason connected with short-term stock market sentiment. Whoever said that the stock market was totally efficient?
The tech bubble was a once-in-a-career event when no conventional valuation-based approach worked for stock market investing.
Given that many companies in the tech boom had no turnover or profits, they could not be blown off course by profit warnings.
Cashflow valuation techniques can be a valuable tool for investing in growth stocks.
Head of UK intermediary distribution
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