Free cash flow to be targeted for payouts

PUBLISHED : Sunday, 28 November, 2004, 12:00am
UPDATED : Sunday, 28 November, 2004, 12:00am

Expect to hear a lot more talk about free cash flow from stock analysts in the next few years. The term refers to a simple accounting principle which says a lot about the dividend payout shareholders can expect, according to Fidelity Investments fund manager Lee Kongchung.

Usually, investors look towards earnings as an indicator of a company's financial health. It is commonly thought the greater the company earnings, the more they will hand over in the form of half-yearly dividend cheques.

But that is a serious mistake, says Mr Lee. For one thing, earnings do not measure the amount of money a company will have to pitchfork back into the business in the form of capital reinvestment.

A computer chip company, for example, will have to spend a lot more to keep up with the latest product and manufacturing advancements than, say, a bank. In theory earnings for each company could be the same, but the computer company is likely to have a much smaller free cash flow after deductions for new capital investment. The bottom line: the bank has more cash.

'Free cash flow is a lot more important in driving the value of the business or the company,' Mr Lee says. 'If the company has to reinvest heavily, the earnings do not translate into free cash flows.'

Low bank interest rates have increased demand for high dividend-yielding stocks. But investors are also paying attention because of an admirable track record.

When performance is averaged over bull and bear markets, Asian companies with the highest dividend yields have consistently outperformed companies with low dividend yields, according to Mr Lee. High dividend-yielding stocks are also less volatile, partly because shareholders are less likely to dump stock when it provides a steady income stream.

Fidelity is moving to fill the growing investor appetite for dividend-yielding stocks with a purpose-designed fund that focuses solely on Asian companies. It says the Asia Pacific Growth and Income Fund is designed to fill a gap in the market between guaranteed funds and volatile mutual funds.

'There are very few products positioned in the middle of the risk/return profile spectrum,' says Mr Lee, who will manage the new fund.

The fund will focus on high-yield financial equities, which are expected to account for 37 per cent of holdings. Consumer discretionary stocks and industrials will each account for an additional 14 per cent of holdings. Hong Kong will be its single largest market with 26.6 per cent of total net assets, followed by Korea with 15.4 per cent and Taiwan with 13.3 per cent.

Mr Lee believes Asian companies have some of the best prospects for boosting dividend payouts. They have cut debt-to-equity ratios from 62.5 per cent in 1995 to less than 20 per cent on this year's estimates, meaning less cash will be used to service or retire debt. The free cash flow-to-sales ratio is trading at close to a 14-year high, and corporate leaders are more willing to return surplus cash to shareholders, with the dividend payout ratio rising from 36.7 per cent in 1995 to almost 41 per cent on this year's estimates.

The fund will carry an annual management fee of 1.5 per cent and launch on December 12.