Wednesday, February 06, 2008

Review on "Free cash flow and shareholder yield" by William Priest and Lindsay Mcclelland

I devoured "Free cash flow and shareholder yield" by William Priest and Lindsay Mcclelland in 2 days.

To be honest, I'm very surprised at how much I 'eat' books these days. It's almost an addiction to learning new things. This book is very interesting, not because of the free cash flow and shareholder yield part, but because of the prediction it had made for US. It talks about the housing bubble, liquidity bubble and hedge fund...three problems that will cripple US economy in the near future. In other words, the two authors had predicted the subprime issue way before the situated became what it is today. I came to understand why the subprime issue is going to be the greatest bubble that US had to face since the era. It's interesting to see how it all turns out to be exactly the way it is described. Great foresight!

Free cash flow means that cash flow after adding in depreciation, after accounting for changes in working capital and after subtracting off capital expenditure (capex). In other words, these cash flow are free in the sense that the company can use it to do anything to enhance shareholder's value. Specifically, the company can opt to do the following:

1. Pay cash dividends
2. Repurchase outstanding shares (i.e. share buyback)
3. Reduce outstanding debts
4. Engage in merger and acquisition (M&A)
5. Reinvest in the business

The first 3 options are known as shareholder yield or shareholder's growth, simply because they increase the value of shareholder. Option 4 and 5 are collectively known as firm growth. It makes sense to think that if the two firm growth options is not equal or greater than the current average cost of capital, then capital should be returned to shareholders instead.

These are the following requirements to build a portfolio based centrally about shareholder yield.

1. An exceptional, robust current cash dividend yield (about 4.5%). Yield should compare favorably with long term bond and greater than that of global equity indices

2. Must be consistent dividend growth - a trailing 3 year compound annual dividend growth rate of 3%

3. Should display enough diversification across countries, across sectors

4. Portfolio is balanced in such a way to reduce risk and to provide a minimum of variance around a portfolio's mean expected return i.e. the much debated beta concept.

I don't really subscribe to the modern portfolio theory, even though point 1 and 2 is a good guide for me.

To screen stocks to fulfill the above requirements, this is what had been suggested:

1. Screen stocks that display 4% or above current dividend yield. 4% is a figure they give, though they emphasize on comparing with alternatives

2. Stocks must have positive operating cash flow growth over the past 5 years

3. Find companies that have increased dividends in more than 50 percent of they years in their available data. It's important that the most recently dividend history possess three or more years of increasing dividends.

4. Cash from operations should exceed dividends over a trailing 3 year period. This is to ensure good dividend coverage (meaning operating cash flow is enough to cover the dividend given out)

5. Find companies whose dividend is 'sacred'. This means that the companies have not cancelled their dividends at any point within their available financial history (20 year max)

Interesting book indeed. There's a lot more that I didn't review though, but those interested can always find this book in the national library.