A paradigm shift is taking place in the sources of return for investors in global equity markets, according to William Priest, chief executive officer of Epoch Funds Management. It is a shift that investors in self-managed super funds (SMSFs) – which have traditionally focused on Australian equities with their tax paid dividends – cannot afford to ignore.
Epoch believes the key to producing superior risk-adjusted returns is not to focus on the traditional valuation measures such as Price-to-Earnings (PE) or Price-to-Book (PB) ratios. Instead, the focus should be on companies that are generating free cash flow and are run by management teams committed to deploying that free cash flow for the benefit of shareholders. Free cash flow is defined as what is left over after payment of expenses, capex and tax.
Epoch’s view is that investors should be positively disposed towards companies that use their free cash flow for the benefit of shareholders in five key ways:
- to make acquisitions
- to reinvest back into the business
- to pay out to shareholders in the form of dividends
- to buy back stock
- to reduce debt
Drawing a line under the first two points, of acquisitions and reinvestment, if a company can pay out its free cash flow in this way, and beat the cost of capital, that is the course of action smart companies should take. But if they can’t beat their cost of capital, it is best to undertake one of the other three options.
PE and PB ratios are a crude and ultimately unsuccessful way of measuring an investments worth. Mr Priest’s research shows that PEs are highly correlated to interest rates. When interest rates reduce, PEs expand, and when interest rates increase, PEs contract.
In an environment of low interest rates, it is hard for PE multiples to expand. Going forward, an increasing amount of return is going to come from dividends and earnings. Both come from free cash flow.
Epoch adopts a strategy of identifying companies that return approximately 6 per cent of their market capitalisation to shareholders on a per annum basis, in the form of cash dividends, share buybacks and debt reductions, as well as possessing an annual underlying growth rate of free cash flow of at least 3 per cent.
This approach will become increasingly attractive to investors, particularly SMSF investors and their advisers, who desire capital growth with substantial income as an investment objective.
We are expecting the investing habits of SMSF investors to shift, and indeed already have seen evidence of this. Traditionally it has been Australian equities – with the benefit of their tax paid franked dividends – rather than global equities that have been in the sights of SMSFs. However, as SMSFs become more sophisticated and educated, they will discover the world of international equities.
