Cash Is King For This Global Fund

Published in Investing on 17 April 2012

A novel stock screen is behind this fund's performance

It's a well-known adage that cash is king. 

At the company level, businesses need to generate cash -- and not just paper profits -- to survive and prosper. And for investors, dividends paid as cash are real returns.

Screening for consistent cash generators is at the core of the Guinness Global Equity Income Fund, and its investment process has insights for anyone interested in value investing. Furthermore, with a new ‘X' class of shares to be offered through fund platforms, carrying a 0.75% annual fee and estimated 1.24% TER, the fund is at the cheaper end for those seeking an actively-managed global income portfolio.

Guinness Global Equity Income was the third best performer in the IMA Global Equity Income sector in 2011, its first year since launch, with a +2% return against a fall of -2% in the sector and -4.8% in the benchmark MSCI World Index. However, so far this year, the fund has lagged behind the indices.

Screen

The fund's main screen is to select companies that have achieved a cash flow return on investment (CFROI) of more than 10% for each of the past ten years. CFROI is a measure of a company's efficiency in generating cash, more of which in a second.

Guinness Global Equity Income is a large-cap fund, so companies with a market cap of less than $1bn are screened out. Companies with gearing in excess of 100% are also eliminated, to reduce balance-sheet risk.

The managers have back tested the screen on all global listed stocks since 2000, and there are some fascinating results. On average, in any one year a quarter of companies achieve a CFROI above 10% -- that's roughly double the real cost of capital, so those companies are making impressive real returns for shareholders.

But less than 3% of companies, 400 out of a global universe of 14,000 listed stocks, have achieved that 10%-plus over each of the past ten years. So the fund's requirement for consistency really separates the wheat from the chaff. The screen rules out cyclical companies, and favours businesses that have a clear sense of capital budgeting: using their financial resources to generate consistent cash returns.

The leverage and scale filters reduce the investable universe to 300. The managers then select 30-40 equal weighted stocks, applying value, sentiment and momentum criteria, to achieve a portfolio yield of 3-4%.

Dividends

Perhaps surprisingly, the screen doesn't just throw up high yielders -- around half yield less than 2%. But their cash flow provides the capacity to pay consistent and rising dividends.

There's a lesson here. Cash is king, but yield isn't. A high yield alone doesn't support consistent share-price appreciation. The iShares UK Dividend Plus (LSE: IUKD) ETF lost nearly half its value in 2008/9.

What is impressive, though, is the consistency of the cash generators. According to Guinness's back testing, 93% of companies that deliver a CFROI for ten years go on to do so in the eleventh.

Putting together consistent cash generation and a yield screen produces even better results. Since 2000, the cash screen universe made an 11.1% return compared to the MSCI World Index's 6.6%. But selecting only those companies with a yield of more than 2% increased the return to 14.7% -- more than double the return of the index.

That looks to be a powerful screen to me. Though Guinness Global Equity Income has a global, large-cap remit, it would be interesting to apply the fund's methodology to UK stocks and small caps.

Geeky

If the process sounds a touch geeky, that's no surprise. The co-managers at Guinness Global Equity Income are both young physics graduates. The fund is not a seasoned stock pickers' portfolio, but a scientifically constructed one.

And CFROI is one of the geekiest ratios. There are a multitude of different versions of how to calculate it, and Credit Suisse has even tried to trademark it. Essentially CFROI aims to capture how efficiently a company generates surplus cash from its financial resources, analogous to return on investment but looking at cash rather than earnings.

Personally I doubt the bells and whistles add much. The simplest DIY variant is to use net cash flow, so:

CFROI = Net cash flow from operating activities/Market cap.

A more sophisticated version would deduct maintenance capex from net cash flow. That's the capital a company needs to spend to maintain its earnings and cash generating power. You can usually get a good grasp of what capex is maintenance and what is discretionary from a company's annual reports.

Top ten

The equal weighting of fund constituents prevents any mega-caps dominating the portfolio. About half of the fund's holdings are domiciled in the US and 30% are from the UK. But Asian and other emerging market companies are increasingly entering the universe.

In the top ten holdings is Meggitt (LSE: MGGT), one of several companies currently benefiting from the boom in commercial aerospace. That's good evidence the screen throws up quality companies.

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Comments

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mcturra2000 17 Apr 2012 , 7:59pm

It's an interesting idea, but what does using market cap as a denominator really tell you? It just seems to be saying that the market has historically rated the company's cashflow highly or lowly. So what?

It did give me an idea, though, of looking at free cashflow to NAV - figures that are readily available from a service like Sharelock Holmes. Those figures were quite revealing. Looking at housebuilder Bellway, for example, you can see that FCF/NAV jumps around all over the place, and is occasionally negative. So it spots it as a cyclical. It's median value over the last 5 years is 6.9% - quite a low figure.

Compare that with a company like BATS (British American Tobacco). Over the last 5 years, its median FCFNAV was 37.7% - a monster cash gusher, as you might expect.

TSCO (Tesco) has a median of 8.6%, with values fluctuating from a low of 2.6% to a high of 25.1%. There was more volatility than I anticipated, and the fact that the median was reasonably low kind-of confirmed it as a pretty low-margin business.

Interesting, no?

TRhere 18 Apr 2012 , 11:07am

Mcturra2000,

That's a very interesting idea. It's the cashflow equivalent of looking at RoE rather than something like earnings yield. I guess there's arguments both ways, but ultimately the proof of the pudding is in the eating - and your measure produces insightful observations on Bellway, Tesco and BATS.

I'm not sure you can draw too many conclusions from comparisons *across* sectors on your measure - different sorts of businesses have different balance sheet structures.

You're right that the CFROI figure is determined by market sentiment. In a sense I suppose the screen is throwing up value companies which consistently offer lots of cashflow at a cheap share price.

Thanks for your very thought-inducing comment.

Tony R

equitybore 18 Apr 2012 , 11:21am

A simpler way of looking at this is to use FCF/sales - easier to calculate...and probably just as valuable

BetaAdjusted 19 Apr 2012 , 1:09pm

Pretty obvious ... I was thinking of doing precisely this, initially with ROCE, and then with CFROI (a much more complicated calculation). I particularly like the equal weights - a proper scientific approach, none of this MPT/CAPM nonsense.

Instead of market cap, I would be inclined to use invested capital i.e. Equity + total debt. So CFO/invested capital ... not CFO/market cap.

I'm working on systematic equity systems myself, based on ideas coming from academic research from the US as I believe the time is now ripe for this approach. I'm going to run a screen on this although I only have 6 - 7 years of data in my database and it is UK only. Might share results here if any interest?

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