Free Cash Flow or Bust

Investors are often encouraged to embrace change. Those who anticipate it better than others can and often do reap huge rewards.

Income investors are a much less adventurous lot, by necessity. Ideally, they’d prefer that nothing change, since any change might jeopardize the income that drew them to their investments.

If everything remains the same, so will the payouts. That might not make for the most exciting world, but excitement doesn’t pay the bills; predictable income does.

Predictability is key, because it’s what assures us that a dividend paid this quarter will be paid again the next one.  Capital gains can come and go, but regular dividends reinvested promptly are truly an investor’s best friend.

Over the last 30 years, the Standard and Poor’s 500 index is up 727% based on price alone, returning 7.3% a year on average over that span. But factor in the dividends paid in that time by S&P 500 companies, and assuming they were reinvested the average annual return increases to 9.7%, while the total gain soars to 1,489%, doubling the appreciation of the index.

You can calculate similar numbers for any other period and even adjust them for inflation here.

Unfortunately, useful though a high dividend yield is, it’s not exactly the hallmark of a quality investment. The novice looks at a high yield and runs to the compounding calculator to figure out just how rich he’ll be in a decade or two. The pro who’s paid his dues wonders why the yield is so much higher than normal, and starts looking for the skeletons in the corporate closet. They’re usually there.

What really matters to the sustainability of the yield is the quality of the cash flow supporting it. The safest payouts are those made out of free cash flow – that is, cash generated from operations net of capital spending. Without free cash flow, distributions are forever competing with capital needs for corporate funds, and can be endangered when financing dries up.

That’s exactly what happened over the last couple of years to many high-yielding energy partnerships. Low energy prices chipped away at their cash flow, of course, but not enough to imperil the distributions. Those were done in by the fact that those MLPs, as they’re known, still had huge, expensive projects in the works. Their operating cash flow could support distributions or capital spending, but not both. When market declines raised the yields they also jacked up the cost of equity capital, making equity sales an impractical financing source. When lenders and the credit rating agencies pulled back as well, some partnerships and companies had no choice but to cut the dividend in order to pay for growth.

Of course, most didn’t have to take that step. Our portfolio at Income Millionaire includes many MLPs that have not merely maintained their distributions but continue to increase them. But there’s no question that the industry’s reliance on external funding is a risk, given growth plans that are once more getting ambitious.

Incidentally, I’ve also recommended a technology stock that yields an annualized 6% even though the company is spending barely more than half its free cash flow on this generous dividend. That buffer of surplus cash is the best guarantee that the dividend will continue to rise. The company’s resilience in the face of change and its aggressive cost-cutting don’t hurt either.

Still, it’s one company, and if something were to go really wrong the entirety of its dividend yield would be in question.

A diversified income fund minimizes company-specific risk. If one fund holding cuts its payout, it’s still just one among the many in the fund’s portfolio.

And there are still closed-end funds out there with blue-chip stock portfolios that are offering annual yields of 8-9% based on regular monthly distributions.

But you need to read the fine print. Some are paying out past capital gains rather than current dividend income. Those distributions could be at risk in a bear market, especially since many of the funds invest borrowed cash to leverage their portfolio’s performance.

At Income Millionaire, we worry a little about current yield and a lot more about the quality of the cash flow supporting it. That way we’re less likely to suffer a nasty surprise if something changes.