Dividends and cash flow are key to long-term returns. Here’s 2 stocks that fit the bill

As Aussie investors, we all love a juicy dividend. 

Dividend-paying shares provide a reliable income stream and are the staple of many retiree portfolios.

It turns out we Aussies aren’t the only ones who love dividend-paying stocks. New York based Epoch Investment Partners believes that the growth of free cash flow and the intelligent use of that cash flow (i.e. returning large chunks to shareholders) represent the best predictor of long-term shareholder return.

As Kera Van Valen, Portfolio Manager for the Epoch Global Equity Shareholder Yield Funds tells it, the philosophy centres around “finding companies with sound capital allocation policies, strong cash flow growth, and an emphasis on returning cash to shareholders in the form of dividends, share buybacks and debt reduction."

"That's what we collectively refer to as shareholder yield,” says Van Valen. 

History is on Epoch’s side when it comes to this approach. Dividends are always positive contributors to equity market returns, and companies with growing free cash flow streams are almost always positive contributors to equity market returns over rolling 10-year periods.

Epoch sees these elements as “more stable drivers of returns” and subsequently believes that building a globally diversified portfolio of companies that generate a sustainable and growing stream of cash, and consistently return much of the excess cash flow to shareholders, will deliver market-like or better returns over the cycle, but with lower volatility.

In the following, I dive deeper into how Epoch hunts for these opportunities, why now could be an opportune time to participate in the strategy, and two stocks that stand out from the pack. 

The markets, they are a-changing

I’ve yet to meet a fund manager with a strategy that outperforms in all market conditions. Van Valen is forthright in saying that the recent period of strong but narrowly led performance has not been ideal for the strategy.

Epoch prioritises diversification as part of its risk management framework, and while dividend yield-oriented strategies have participated in the strength of the market, there has been some pressure on the relative return given the short list of stocks that have dominated returns.

Things are starting to change, however. The Great Rotation, away from large-cap tech and into smaller-cap stocks, has seemingly begun, and volatility is picking up from historical lows amid geopolitical tensions, election uncertainty, and general uncertainty surrounding the path for global economic growth.

These are the conditions that favour the strategy.

According to Van Valen, a lot is going on right now that is supportive for shareholder yield and equity income investing.

“Corporations are in a strong position to continue to generate healthy levels of free cash flow, which will allow for sustainable cash distributions back to shareholders,” says Van Valen. 

She adds that as the US moves back to a more normalised interest rate environment, companies will need to be more disciplined in their capital allocation approach.

"Epoch’s focus is on companies with track records of maintaining and growing their cash flows throughout economic cycles," says Van Valen.

Along with strong pricing power and sound capital allocation practices, these factors mean the portfolio is well-positioned to be more resilient in volatile periods while participating in rising markets. This allows the strategy to deliver market-like returns with less volatility.

The impact of AI on cash flow generation

AI has touched every part of the market, just as it will likely touch every part of the economy at some point. While Epoch is a long-term investor focused on free cash flow generation and shareholder distributions, it does have some exposure to the early AI enablers that have driven a lot of excitement.

That is not the main game, however.

For Epoch, the excitement of AI is not the near-term impact focused on building infrastructure that has juiced markets and some particular stocks – think chipmakers and data centres. Rather, the excitement is in the longer-term utilisation of the technology, which “has potential to boost top and/or bottom line growth for companies who harness it effectively” says Van Valen. 

"Utilisation will not only see an acceleration of growth, but you're also likely to see an acceleration in the cash flow generation and, therefore, the cash available to be returned.”

Some early use cases

Van Valen points out that while just about every company talks about its AI strategy on earnings calls these days, there are a couple of areas of the market where activity goes beyond talk—namely, consumer and healthcare.

“Within the consumer space, retailers are one segment where we're already encountering successful AI implementation,” says Van Valen, highlighting companies that have extensive inventory and warehousing needs and which are “challenged to make sure they're ordering an appropriate assortment in the sufficient quantities that they need”.

AI-supported inventory and staff management tools allow such companies to protect competitive advantages but improve the return on invested capital and grow cash flows.

Regarding healthcare, AI is being implemented in drug discovery and development, shortening the road from initial research to conceptualisation, then into trials and, ultimately, approval for use.

“AI integration into this process has already begun,” says Van Valen, adding that “it is shortening the timelines”.

This opens the door to not only a rising number of novel therapies being discovered faster “but also provides a promising growth vector for revenues and free cash flow generation,” says Van Valen.

The non-negotiables

Whether AI-related or not, there are some non-negotiables that every company that makes it into the portfolio must exhibit.

Strong, consistent and growing cash flow generation tops the list, with Van Valen adding that companies must exhibit at least GDP-like growth.

“We would like the growth to be faster, but we want to see that a company’s cash flows are growing in line with the overall economy at a minimum,” says Van Valen.

Sound capital allocation policies that emphasise returning excess free cash flow to shareholders in a consistent and predictable fashion is another non-negotiable, with Van Valen saying, “Ideally, we want the distributions to come from reoccurring sources”.

"That's what allows for the sustainability of the distributions over time."

Companies must have a track record of growing their dividends, particularly over the past three to five years. A sound balance sheet is also important as it allows companies to withstand bad times and protect their ability to pay dividends. 

How are you investing right now?

It is perhaps this last point, about a sound balance sheet, that allows Van Valen to confidently say that she has not seen the opportunity set shrink or expand with any significance as the market has endured rising and potentially now falling interest rates.

"We have not seen the opportunity set shrink because of the rise in interest rates, nor would we expect it to change materially if interest rates ticked down slightly in September,” says Van Valen.

She adds that the opportunity set remains “quite robust” with the outlook for dividends strong.

“We see no reason for management to abandon sound capital allocation practices,” says Van Valen, adding that cash flow generation remains strong, more companies – particularly in Europe – are starting to adopt a more balanced approach to returning cash to shareholders, and even some of the Magnificent Seven companies have recently introduced dividends.

“This is all very exciting to us because it just further expands our opportunity set."

Two stocks Epoch likes

When pressed for a couple of stocks that fit the bill, Van Valen nominates recent portfolio addition Hewlett Packard Enterprises (NYSE: HPE) and Williams Company (NYSE: WMB).

Hewlett Packard has benefited from its growing AI server business, according to Van Valen, and “is one of the key collaborators with NVIDIA, providing full turnkey AI solutions including compute, storage, and networking."

“Cash flow growth is achieved through volume growth, content gains, new program wins, and margin expansion,” adds Van Valen.

Williams Company is a midstream energy company in the US that provides natural gas gathering, processing, transportation and storage services.

According to Van Valen, the company has continued to deliver strong earnings in recent quarters by reaffirming a healthy growth outlook that is supported by rising demand for natural gas from manufacturing, reshoring, liquefied natural gas exports, AI data centres, and the general electrification of transportation.

“The company has a stable and robust cash flow profile, and that is primarily driven by the fact they have mostly fee-based contracts, so not as tied to the underlying commodity, and the cash is returned to shareholders through an attractive and growing dividend."

A final thought

There are many good reasons to be optimistic about equity markets right now, says Van Valen, “but narrow markets like what we have witnessed this year can lead to a loss of portfolio construction discipline and a lack of awareness around broader concentration risk”.

"I think it's even more important now to make sure you're disciplined in your portfolio construction, aware of the aggregation risks of stocks with similar exposures, and that you manage the intended risk prudently," says Van Valen. 

She adds that current market exuberance should be contextualized, noting that market leadership has been very narrow and that extreme market concentration can fuel a bit of FOMO-driven decision-making. 

"We think investors would be well served to take the opportunity to diversify, to find value in less crowded parts of the market, and really consider risk management," says Van Valen.

Managed Fund

Epoch Global Equity Shareholder Yield Fund (Hedged)

Global Shares

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Managed Fund

Epoch Global Equity Shareholder Yield (Unhedged) Fund

Global Shares

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