When the market is topsy-turvy, it's worth making sure you have some cushions in your portfolio. Stocks that pay dividends provide not only extra bang for your buck, but they're also considered steadier and tend to outperform ones that don't. Two managers that hunt for companies with healthy free cash flow to pay dividends are Dick Dahlberg, 67, and Scott Davis, 50, skippers of the Columbia Dividend Income Fund (LBSAX). They hold companies that tend to have higher return on equity—a measure of how efficiently companies deploy their capital—and are less leveraged than the market. "These are companies that can sustain themselves," Dahlberg says.
Dahlberg observes that "we're very long in the tooth in the [economic] cycle," and they're seeing a lot of companies going from positive free cash flow to flat or negative free cash flow. "Companies have been investing their money in new products and that's coming at a higher cost," he says.
The Boston-based duo also considers valuation, using free cash flow yield (free cash flow from operations per share divided by the stock price). Their top holding (as of Jan. 31) is AT&T (T), followed by a raft of other blue chip names: Exxon Mobil (XOM), General Electric (GE), Pfizer (PFE), Verizon (VZ), Citigroup (C), Altria (MO), Lincoln National (LNC), McDonald's (MCD), and Chevron (CVX).
Clearly, they're doing something right. For the three-year period ended Jan. 31, Columbia Dividend Income Fund (A shares) had an average annualized total return of 13.6%, vs. a total return of 10.3% for the S&P 500 index (Standard & Poor's gives the fund its second-highest rank of 4 STARS). That also beat the 12.16% three-year return for large-cap value funds tracked by Morningstar. For the last year, the fund has risen nearly 19%, vs. a 16.13% average gain for its peers.
BusinessWeek.com's Karyn McCormack spoke with Dahlberg and Davis on Mar. 2 about the stock market and why investors should focus on free cash flow and dividends. Edited excerpts of their conversation follow.
What do you make of this week's wild ride?
Dahlberg: It's long overdue. Everybody had become too complacent.
Davis: What struck me the most was every Wall Street strategist was bullish. Everybody bought into the "Goldilocks" scenario (see BusinessWeek.com, 2/1/07, "The Fed: It's a Goldilocks Economy"). One of the surprises was reported earnings rose at a double-digit pace for so long, with fourth-quarter growth coming in above 10%, and I think there's a perception that that's the norm. It's partly about fundamentals and economics, but partly about investor perception—and I think that got ahead of itself.
Do you consider this a buying opportunity?
Dahlberg: Prices got well ahead of fundamentals. Prices have come down quite a bit to give some buying opportunities. But this is not a one-week phenomenon—it could take a while to shake out.
Davis: This has been a market where people have no respect for risk and they have not been compensated for taking risk. Now we're at the point where people are reassessing that.
Are you making any changes to the fund?
Dahlberg: We're not making any radical changes at this point. We took our position a few months ago, and became more conservative.
How is it positioned?
Dahlberg: Our portfolio has a greater emphasis in health care and consumer nondurables. We have less emphasis on energy and less in the industrials area.
For example, we like Johnson & Johnson (JNJ)—it's trading at 16 times this year's earnings. We also own Nestlé (NSRGY). In the fourth quarter we added Coca-Cola (KO), and before that we bought shares of Anheuser-Busch (BUD).
We were also very heavy in the telephone stocks last year. They had huge free cash flow. And we also owned a few REITs that were taken over. Equity Office Properties and New Plan Excel Realty Trust (NXL) were both taken out in the first two months of this year.
What do you focus on the most?
Davis: Our philosophy is simple: We look for companies that can generate substantial free cash flow that are able to give it back to shareholders in the form of dividends. Free cash flow is hard to fudge, while earnings can be manipulated a little bit. We believe a company's ability to generate cash gives it its value over the long run.
Free cash flow peaked about a year ago for corporations. Now it's on the decline because they're spending money hand over fist.
Dahlberg: On average, companies have about a 3% free cash flow yield. We look for 5% and above free cash flow yield. We focus on operating free cash flow—net profit from operations, making adjustments for working capital, then we add back depreciation and subtract capital expenditures.
What do you like to see companies doing with their cash?
Dahlberg: There are five things companies can do with cash. They can reinvest the money to expand the business, pay dividends, and pay down debt or buy back shares. There are two negative things also: Dilute [stockholders' equity] through issuing options, and buying other companies.
Davis: Private equity has raised an awful lot of money, and there's a lot of talk that nothing is beyond their scope. That creates a lot of pressure on companies with a lot of free cash flow on their balance sheet to do something quickly (see BusinessWeek.com, 2/21/07, "Five Stocks With the Most Cash").
For example, we think McDonald's has done a great job of running its business, but we thought they should return some cash to shareholders. Last year, they did that in two ways. For the first time, they're shrinking their share count. And in December, it increased its dividend, so it went to a 2% yield very quickly. McDonald's has done a good job of refocusing the company to be more about the customer that walks through the door rather than passing by in the drive-thru.
How many holdings does the fund have? What's the largest?
Dahlberg: We have 91 stocks. Our turnover is generally 30%, so the average holding period is about three years.
AT&T is our biggest holding now. Our largest telephone holding in 2006 was BellSouth, so we got the takeover by AT&T.
Why do you like AT&T?
Davis: It's the cash flow. We think they're in an interesting position right now. People were beating them up over their landline losses, and the assumption was they would lose clients and cash flow. But I think we'll see them gaining over the cable companies.
Dahlberg: It's being driven by the business enterprise market—that's a growth market and it is well established. Wireless is the second growth business. We also see their entry into the video market as being another growth avenue.
What's the greatest lesson for investors?
Dahlberg: It's easy to focus on what's happening this afternoon, but we tend to think in long time frames. That's where we think the investor can have an edge over institutions.
Davis: As I've gotten older, I've gotten more patient. What I've learned is good companies are fairly priced. I want to compound returns over time. So buy good companies and have patience.