Cash Flow Is Still King

Nicola Wealth Chairman and Chief Executive Officer, John Nicola, once authored a newsletter to clients titled "Cash Flow is King." In that newsletter, he emphasized the importance of incorporating investments that generate a regular income for our clients. This income is a key advantage of investing in dividends and cash flowing assets. In this article, we revisit some of our previous findings and explain how a declining stock price can potentially signify better value and future returns.

Let's consider a scenario: At the end of 2019, an investor owned a well-managed company valued at $2 million, generating an annual income of $100,000 after expenses. Through hard work and smart decisions, this income increased to $150,000 by the end of September 2023. The investor thought about selling the business, retiring, and moving to Bora Bora. However, when he tried to sell the business, he received a bid of only $1.8 million.

Perplexed, the investor said, "This can't be right. My business now earns 50% more than it did at the start of the pandemic. Why has its value decreased? This doesn't make sense." The investor may have a valid point. In a short span, his company's valuation dropped from 20 times earnings to only 12 times. It might not be the right time for him to sell, but it could be an excellent opportunity for someone else to buy. What's your perspective on this?

Your initial reaction might be to side with the investor. However, this scenario mirrors what's happening in the public markets with many well-known Canadian blue-chip companies, some of which we hold in the Nicola Canadian Equity Income Fund. Looking at the chart below, these companies are generally leaders in their respective industries and have a proven history of increasing dividends and returning capital to shareholders. Despite the challenges posed by the global pandemic, this group of companies managed to increase their dividend per share by an average of 35% since the end of 2019. Surprisingly, investors have shown lukewarm interest, with their average share prices now 9% lower than at the close of 2019, translating to approximately 3.75 years of stagnant share prices.

It's possible to rationalize the reasons behind these corrections. One of the major sources of concern has been the rapid rise in yields. Persistent inflation, exceeding central bank targets, has led to an adjustment in bond yields to accommodate a "higher for longer" narrative for the interest rate environment. Bond yields have consistently climbed since the spring of this year, with Canadian 10-year bond yields reaching 4.2% in October – a level not seen since 2007. Elevated interest rates raise several questions for investors:

• Higher interest rates could impede economic growth and impact consumer spending, resulting in a revenue challenge for our dividend-paying businesses.
• Elevated interest rates could mean higher interest expenses for businesses, leading to reduced free cash flow for distribution to shareholders, constituting an expense concern.
• Higher interest rates may cause a general decline in P/E ratios as fixed-income products become more attractive to investors compared to when bond yields were closer to 0%, leading to a valuation challenge.

Each of these statements holds some truth, which might push a rational investor to make an irrational decision, such as selling a sound business that is now paying relatively more in dividends to investors, despite having a decreased valuation. We see this as a time to differentiate between businesses. Some companies offer a dividend yield but could be considered "Value Traps." Identifying companies likely to grow their dividends in the future presents a real opportunity.

Keep in mind that equity prices generally tend to fluctuate more than the underlying dividends. As John Nicola once said, "Dividends represent the rational discipline of a well-managed company, while the price reflects the collective behaviour of investors, often behaving irrationally." Therefore, it's essential to expect (irrational) volatility in equity pricing. Being a successful investor means having a strategy in place for handling price corrections and capitalizing on the opportunities they present.

Dividends play a crucial role, and their yields are at present generally higher than they have been in the past decade. If you doubt the significance of dividends in terms of total returns, consider the following statistics. Between September 2013 and September 2023, the price appreciation of the S&P/TSX Composite Index was +53%, translating to a 4.3% annualized return. When factoring in dividends, the total return increases to +107%, more than doubling the value, resulting in a 7.6% annualized return over the same period. Many robust dividend-paying companies have seen dividends and earnings grow while stock prices remained stagnant. In our table above, the dividend yield for the list of Canadian dividend-paying companies has risen from 4.2% to 6.2%. These higher dividend yields align with our goal of generating income for our investors.

However, it's worth noting that dividend growth strategies have underperformed recently. The rising interest rate environment has caused both bonds and bond proxies (equities held for their attractive yield, in lieu of bonds) to decline in price, making their yields appear more attractive. We've examined current dividend yields and observed that for many companies, these yields are currently at or near the top end of their historical range.

We favour dividends and disciplined purchasing. To acquire assets efficiently for our clients, we need the assets we desire to experience price drops. While we cannot predict precisely when dividend strategies will regain favour, we are confident that investors will return when inflation subsides and interest rates stabilize. Over the long term, dividend growth has proven to be a robust investment style, and we appreciate that we are currently being rewarded with substantial income as patient investors.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances.  Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required securities commissions. All values sourced through Bloomberg, unless otherwise specified.