Management teams have a corporate responsibility to act in the long-term interests of their company and its shareholders. However, the current investment climate – increasingly uncertain, with higher market volatility than that seen over the last couple of years – tends to encourage short-termism and a focus on returning cash to shareholders, in many cases to the detriment of long-term growth.
In this environment, our focus continues to centre on companies with strong balance sheets and cashflows, particularly those able to reinvest those cashflows in their business for future growth. High quality companies that display these characteristics may seem to trade on high market-relative valuations but the ability to grow – even in a low growth and uncertain world – is a rare and valuable attribute.
Since the financial crisis developed economies have entered a phase of muted growth as consumers, governments and banks continue to reduce leverage. In the developing world we have seen slowing growth rates as countries such as Brazil and China have been affected by lower credit growth. In addition, companies now trade with elevated margins as management teams have restructured cost bases, driven down working capital and refinanced debt at very low levels. Therefore, if one combines the fact revenue growth is muted, margins are high and valuations have recovered, from here companies must take additional action to stimulate growth.
The adage “cash is king” still remains as relevant in investment today as it did a century ago. Frustratingly, companies and the majority of sell-side analysts obsess about earnings data and post-tax profits, whereas underlying free cashflow can tell a very different story.
Profit numbers can be manipulated and so a focus solely on profits often misleads as to the true growth of the company and can mask the fact the returns on investment are falling. What cannot be manipulated is how much cash a company actually generates. Before shareholders have access to the cashflow, the company must meet the general running costs of a business, pay the taxman, pay interest on any debt, pay their pensioners and purchase stock required to operate. What matters to us as shareholders is the cash left over after all these payments have been made. We call this the “free cashflow to equity”.
The company then has a choice about what it does with this free cashflow, as shown in the chart.
Should cash be returned to shareholders via dividends or share buybacks or re-invested for future growth? It is this capital allocation decision made by management that is a key determinant of the long-term success of a company.
Given the global search for yield, companies that have focused solely on returning cashflows to shareholders through dividends and buybacks have performed well in recent years and an appropriate dividend policy can be beneficial to a company’s strategy as a way of demonstrating capital discipline. Crucially, however, a long-term growing dividend can only be ultimately paid out of growing free cashflow, not from increasing debt levels. True wealth creation and growing a company’s long-term cashflow requires investment.
The organic reinvestment of cashflows to grow the manufacturing footprint, product set, geographical reach or sales force is an obvious way to increase revenue. However, this investment has to be rational and lead to improving returns. For example, the food retail and mining sectors have shown in recent years that simply increasing capital expenditure can destroy shareholder value if the returns do not cover the cost of capital and increased spending leads to industry overcapacity.
M&A is another area where capital can be deployed to the benefit of long-term shareholder value. In the right circumstances M&A can lead to increased efficiencies, better growth opportunities and increased industry consolidation. Sometimes growth can be better achieved by acquisition, as evidenced by Royal Dutch Shell’s recent bid for BG, which provides quicker and more reliable access to energy resources than was available organically to them. Other examples of successful inorganic growth, where bolt-on acquisitions have expanded network reach and strengthened market positions, include DCC and Bunzl.
In a world of low interest rates, anaemic economic growth, elevated margins and fair-to-high valuations, we continue to focus on companies able to generate cash and whose management teams have the ability to re-invest it for the long-term benefit of shareholders.
Simon Brazier is manager of the Investec UK Alpha fund