Why free cash flow (and not cash) is king

Many fund managers have a key factor or process that anchors their investment philosophy. It could be the return on tangible capital, the quality of management, or sustainable yield.

In the case of Epoch Investment Partners and the Epoch Global Equity Shareholder Yield (Unhedged) Fund, free cash flow is the key factor.

The Epoch process has been built to uncover opportunities that others may miss. It is also predicated on the belief that free cash flow - and the intelligent use thereof - represents the best predictor of long-term shareholder return.

"We began with the understanding and the belief that the value of a firm depends upon the cash flow that the business generates over time," say Kera Van Valen and John Tobin.

In this special edition of Expert Insights, I was fortunate enough to be able to pose questions to both Van Valen and Tobin, who are managing directors and portfolio managers at Epoch.

In the interview, they discuss the key elements of the Epoch process and how they drive performance, how they view share repurchases, manage volatility, and, of course, the importance of free cash flow.

Please note: This interview took place on 9 March 2023.

Edited Transcript

What are two key elements of your investment philosophy and how do they drive returns?

Kera Van Valen: The two key elements of our investment philosophy are free cash flow growth and sound capital allocation. 

If you think about the longer-term drivers of equity market returns, dividends and earnings growth are the more stable drivers of returns. 

You can think of earnings growth as a long-term proxy for free cash flow growth. When we're building our portfolio, we want to find companies that have growing free cash flow streams, but also emphasise returning cash to shareholders in the form of dividends, share buybacks and debt reduction.

Why is free cash flow, and the intelligent use thereof, so critical to your process?

John Tobin: 

Free cash flow is really a foundational concept for 

Epoch Investment Partners. 

From the beginning, we began with the understanding and the belief that the value of a firm depends upon the cash flow that the business generates over time. And we have a preference for cash flow rather than accounting metrics, EPS, price to book, those kinds of measures that are traditionally used. 

The thought is that those accounting-based measures, because they're based on accrual accounting principles, can lead to timing differences between the time that revenues are recognised, for example, and the cash flow actually comes in. So we focus on cash flow. 

From there, we have a model that we refer to as our five uses of cash model, and the thought there is that there really are only five potential uses of cash for any business, and they are simply the following; 

• A company can invest cash to grow organically through capital expenditures and R&D spending. 
• It can invest to grow inorganically, by making acquisitions.

It can return cash to the owners of the business through: 

• dividends
• share buybacks, and
• debt reduction

The last three are the ones that we refer to as shareholder yield. 

So, that's our focus, trying to understand how a company generates cash and how the management team invests that cash. And importantly, can they get the balance right? Can they be good capital allocators? 

By that we mean can they invest a return above their cost of capital, and identify opportunities that have that opportunity to generate a return above their cost of capital? 

And then when they run out of those wonderful ideas, understand that what they should then do with their access free cash flow is give it back to the owners of the business through dividends, share buybacks and debt reduction.

You consider share repurchases “dividends by another name”, can you explain that line of thinking?

Kera Van Valen: The tangible benefits of share repurchases might not be as obvious as cash dividends. However, if you think about the value of a company as being the future free cash flows of that company, the value of a company wouldn't change whether you're doing a share buyback or paying a cash dividend.

But when you do a share repurchase, you're lowering the amount of shares outstanding, so each remaining shareholder has a larger claim on the future free cash flow of the business. In addition, share repurchases actually offer flexibility because there's less of a stigma attached if you dial up or down your share repurchase program. 

So it's a way that management teams can return cash to shareholders with more flexibility than the cash dividend, which is often stickier.

Managing volatility is an important aspect of your process, how does that manifest in the investment process? 

John Tobin: I think I'd say first of all, it is not a metric that we manage to specifically. Shareholder yield is not a low-vol or a min-vol strategy. 

Instead, the lower volatility is an outcome of the process. 

It reflects the kinds of companies that we're investing in and the way we structure the portfolio. In terms of portfolio structure, we intentionally and deliberately seek to have diversification across sectors, diversification across geographies, we limit exposure to two and a half percent per name in the portfolio. 

More importantly, really we're looking for companies that have certain characteristics, that are growing cash flow over time, and that are returning some of that cash flow to the owners consistently, year in and year out, paying dividends that are attractive and that grow over time. 

Those are characteristics of a fairly stable business, a business that regularly generates cash flow, regularly grows cash flow, regularly returns some of that cash flow to the owners.

So, if we're looking for companies that are inherently relatively stable and then we put together a portfolio of a hundred such companies, at the portfolio level, the volatility is dampened even further. 

So, not a specific metric to which we're managing, but at the same time, throughout the history of the strategy, it's been a consistent and durable characteristic, lower than market volatility.

About Epoch Investment Partners

New York-based Epoch Investment Partners, Inc. (Epoch) was established in 2004. Its distinct investment philosophy based on the generation and allocation of free cash flow and integrated portfolio risk management differentiates Epoch from other global managers. Click here to find out more about their investment philosophy.