What does a "good" dividend stock look like?

Mia Kwok

Livewire Markets

Epoch has the whole world of dividends at its feet. It is currently invested in the likes of Microsoft and Samsung, as well as US pharmaceutical company AbbVie and German insurer Allianz. But its strategy is not just to chase the big names, rather diversify aggressively in order to reap the reward of underlying yields. 

"I'd say the kind of market environment that we're operating in today is one that is still broadly led, and it's no longer the market environment where the only stocks to own are the FAANG stocks," said John Tobin, portfolio manager of Epoch's Global Equity Shareholder Yield fund. 

Tobin found that in the Great Rebound of 2020, being highly diversified paid off. The fund holds about 100 stocks and has a hard allocation limit of about 2.5%. 

"We have position size limits that we've imposed. So we don't go above two and a half per cent, and as a practical matter, we don't often go above 2%. We start trimming positions when they get to the 2% level," said Tobin. 

But a portfolio of 100 stocks is still a narrow playing field in global markets. So, what do Samsung, Microsoft, Allianz, AbbVie and 90-odd other stocks all have in common, and how to choose who stays and who goes? 

Well, it all comes down to cash flow. 

The red flags for cash flow 

"There's a general rule that applies, and this is one of them. It's so simple, so obvious and true, what they should be doing is investing to earn a return above their cost of capital."

"And it doesn't matter what business you're in, it doesn't matter what industry sector you're in it doesn't matter what region of the world you operate in," said Tobin. 

When it comes to hunting for dividends Epoch hones in on cash flow, in particular, he looks at how management spends its extra cash. 

According to Tobin, there are only five things a company can do with cash flow.
  1. They can invest it for organic growth (internal investments),
  2. They can invest in inorganic growth (acquisitions)
  3. Pay dividends
  4. Buyback shares or
  5. Pay down debt

"The fundamental belief is that it is cash flow that matters, it is cash flow that determines the value of an investment and the value of a business. So we want to understand, how does a business generate cash flow? And then how does the management of that business allocate that cash flow?" said Tobin.

The team will interrogate from the top down, starting with the CEO, COO and CFO as needed. 

"When I ask a chief financial officer: what do you estimate is your current cost of capital? That's something they should be able to answer right off the top of their head. It's a red flag if they don't," he said. 

Tobin has strict parameters around those answers as well. For him, the cost of capital does not imply the cost of borrowing. This is an easy trap for the unwary researcher.

"In the low-interest-rate environment that we're in today, one could be tempted to say if you're a chief financial officer, 'Well, we can borrow it for 10 years at three and a half per cent, so we view that as our cost of capital,' ... (but) we wouldn't agree with that approach," said Tobin, 

"We would much rather hear company management talk about our weighted average cost of capital, or normalised capital, and hope to hear that their estimate of what their underlying cost of capital is more like eight or 9% or 10%," he said. 

What does a "good" dividend stock look like? 

"We're looking for companies that have certain characteristics, what are they, we're looking for companies with a track record of growing cash flow, we're looking for companies with a track record of paying an attractive growing dividend, and we're looking for companies that have strong market positions that give us some confidence that going forward, they will continue to grow cash flow, they will continue to pay an attractive growing dividend," he said. 

One example Tobin provides is MetLife, a US insurance company that managed to increase its dividend payout in April 2020 amid the depths of the pandemic. 

"They were able to communicate to the investment world - to their audience that: our business can actually weather this challenge quite well. The impact on our business from COVID has been quite limited," he said. 

Metlife resumed its share buyback program in the second part of 2020 and in 2021 it raised its dividend again, and instigated a new share buyback program. And while investors love a good dividend stock, for Tobin, it's also about communication and transparency with investors that makes him hold this up as an example. 

The place where cash is still king

Tobin's strategy targets an attractive, growing level of income, lower than market volatility, good upside participation, good downside protection. 

"All of that is an outcome that we seek to deliver from a portfolio. So, that drives us to want to have a portfolio that's well-diversified without significant idiosyncratic risk. So it's not a stock-picking portfolio," he said.

Tobin has given a deep level of thought to this cash-flow based approach. He taught university-level economics in the US, before attaining his PhD in economics. But before he joined the Epoch team nearly a decade ago, he was a high-yield bond investor. 

No one knows the ins and outs of a company's cash flow quite like someone who is willing to lend to them. To paraphrase a great quote of Benjamin Franklin's: "if you ever want to know the value of money, try getting a loan."

Well, if you ever want to know the value of a company, go to its creditors.

"A high yield bond investor learns early on, the only thing that matters is cash flow," said Tobin. 

"Companies have to make coupon payments every six months and they don't make coupon payments with reported earnings, they make coupon payments with money that they have in the bank. So, that focus on cash flow, understanding the cash flow generating ability of a company, understanding the cash flow needs of that business was exactly what was necessary to move into the shareholder yield way of investing. And in many ways, it was pretty seamless," he said. 

Seek superior total and risk-adjusted returns

Epoch’s Global Equity Shareholder Yield investment strategy is simple, straightforward and based on sound principles: invest in a diversified portfolio of high-quality companies that have a track record of generating growing levels of free cash flow while simultaneously rewarding shareholders with a progressive dividend. The architecture of the strategy makes sense, and it works. Find out more.

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Epoch Global Equity Shareholder Yield (Unhedged) Fund
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Mia Kwok
Editor
Livewire Markets

Mia Kwok is a former content editor at Livewire Markets. Mia has extensive experience in media and communications for business, financial services and policy. Mia has written for and edited several business and finance publications, such as...

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