Buybacks and Yield Should be Byproducts of Free Cash Flow

There’s a lot of talk about the superiority of yield-based strategies, and that has been true in hindsight, particularly since interest rates have fallen for pretty much the last 25 years, while corporate profits and free cash flow have generally grown, allowing for greater dividend capacity.  A potent mix that has favored yield, but what if the environment changes?

I don’t go looking for yield, but stocks with some yield tend to find their way into my portfolio.  Why?  Companies with stable business models, strong balance sheets, and good earnings quality tend to produce free cash flows in excess of their reinvestment needs.  That cash can be given to shareholders as dividends, or used to buy back stock.

But there is something positive about what a dividend does to a company’s management team, which in the American context, is viewed as a pseudo-obligation.  This makes the cost of capital tangible to the management team, which will be more careful about how they use their cash.  After all, they have a dividend to maintain.

Now, yield in itself can be manipulated.  Leverage can be increased to pay dividends, and with low quality companies that often happens.  Smart investors look to see how well a company’s dividend yield is covered by the earnings.  Avoid the shares of a company that isn’t likely to earn its dividend, particularly if the have to compromise the balance sheet to do it.

A yield in itself does not make a company more safe; if the yield is high enough such that there are naive yield investors in the stock, that yield can actually make the stock more risky, if a disappointing earnings report puts the dividend in jeopardy.

Finally, as an aside, a quick note on intelligent vs. dumb buybacks.  Intelligent management teams have an estimate of what they think their firm is worth, and they don’t buy back stock, unless the stock is trading below that level.  The management team won’t tell you that level, but they might tell you if they follow such a strategy, if you ask them.

After that, you can find out where they are buying stock back.  If you look in the cash flow statement, under cash flows from financing, you can see how much they spent buying back stock, and in the statement of shareholders equity you can see how many shares they bought back.  Those two figures will enable you to calculate the average buyback price.  This figure can be important even for traders, because it can indicate a level where a management team is willing to buy buy shares when they have free cash, and as a result, can become a support level for the stock.

Good fundamental investing means looking at more than just a few summary variables, like yield.  You have to dig through the financial statements to see how the business adds value.  If that means that your stock gives you a yield, like most of my stocks do, that is icing on the cake.