Why Cash Flow Is Currently More Important Than Earnings

by: The Independent Investor

Wow, dividend investing is back. While the S&P 500 and its tracking exchange traded fund, SPY, as well as market leaders like Apple (NASDAQ:AAPL), had a huge run going into April, most of the broader indexes and market leading stocks have performed horribly over the last month.

Indeed, with the growth outlook uncertain, fear rising in Europe, and no major market catalysts in the near-term, buying stocks now on valuation alone seems risky at best.

Still, despite the recent sell-off in most of the broader indexes, some sectors and stocks have held up well. Without question, the stocks that have held up the best have been companies with high yields.

As we can see, the S&P 500 and its tracking exchange traded fund, SPY, is basically flat for the year. While dividend funds such as the Dow Jones Select Dividend Index (NYSEARCA:DVY), are only up around 3-5% for the year, these funds also yield 3.5%. An 8% a year return in a deflationary environment where most major index funds are flat for the year is impressive.

The problem most mutual and exchange traded funds heavily leveraged to cyclical companies in the industrial sector have had is that forward price to earning ratios are totally unpredictable. With deteriorating economic data in Europe and China, the growth outlook is heavily uncertain. In an environment where cyclical companies are on 1-2 year cycles, there simply is no incentive hold these names when the stock rallies, since investors holding cyclical companies are rarely receiving any dividends of significance.

While some cyclical companies, such as Microsoft (NASDAQ:MSFT) and Apple, have such strong balance sheets, these companies have the flexibility to buy back shares and continue to pay dividends even when the economy is weak. Anyone who says the market is cheap has to have a fairly good idea of what earnings will look like going out 12 months.

Dividend stocks are not just working because of the dividend, many of the leading dividend stocks in the consumer staple sector such as Altria (NYSE:MO), Kraft (KFT), and Kimberly-Clark (NYSE:KMB), are also outperforming the market because they are not cyclical businesses, and these are companies generating significant free cash flow. In a volatile market of 6 month cycles where the 10 year treasury is yielding less than 1.5%, the company with slow but steady revenue growth that can consistently pay a 4-6% dividend is king. The reason is simple - the market knows how to value the company on a price to cash flow basis; even the company's earnings will fluctuate mildly.

Altria, Kraft, and even steadily growing conservative stocks such as McDonald's (NYSE:MCD), are much easier to value. Since the market knows these companies have safe dividends since these companies' earnings have held up strong through the recent period of economic weakness, so investors are willing to own these stocks when the yield on these companies is more than 3% greater than the 10 year treasury.

If Altria can pay a 5% dividend and show positive revenue growth, investors are willing to own it as long as the annual dividend return is twice what short-term fixed income investments will return. Essentially, investors are willing to value companies that pay strong dividends based on these company's current and past ability to generate the free cash flow necessary to maintain and raise these stocks' dividends, not a meaningless and uncertain price to earnings ratio.

To conclude, while I do think a number of cyclical companies with strong balance sheets and solid long-term growth prospects are likely oversold, traders and investors have no idea what the forward price to earnings ratio is today; since the growth outlook is uncertain, near-term returns in cyclical stocks will likley be limited.

While many of the strong companies with consistent and high dividend payouts have earnings that will obviously also be affected by economic outlook, most companies willing to pay a high dividend have strong free cash flow in addition to earnings growth. While companies willing to pay strong dividends often have less cyclical business models, these companies will also likely be much easier for the market to value in an uncertain economic environment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.