Hunt for income: Harsh lessons to be learned

It brings to mind the following quote from Fairholme Capital Management’s Bruce Berkowitz: “Cash doesn’t do the shareholder any good unless management makes smart investments with it, or returns it to its owners via dividends or share buybacks. Management talent and intentions are crucial.”

The question for many companies is whether shareholder returns are generated by investing cash themselves; buying back their own shares or paying out dividends. In the not so distant past, companies were encouraged to gear up heir balance sheets and buy back shares to flatter earnings per share and, perhaps more cynically, to trigger options. This was, more often than not, executed with little reference as to whether or not the shares represented good value.

Conversely, healthy, cash-generative companies with little reliance on debt have a greater opportunity to generate shareholder value using a variety of measures. These are companies whose strong business models and balance sheets afford them control of their own destinies. In short, these are the companies that do not give to shareholders with one hand, while effectively robbing them with the other.

We can illustrate this with two recent and very relevant examples. The first is the acquisition of Cadbury by Kraft Foods. It was always a given that Warren Buffett’s views on the deal would receive substantial coverage, and he did not disappoint. While we all smile wryly at the concept of him feeling “poorer” after the deal, his concern is expressed in very simple terms: the directors of Kraft believe that their shares are undervalued, yet they are issuing shares to acquire Cadbury. In other words, their shares are being exchanged as cheap currency in the deal.

Now to BAE Systems, which has suffered a torrid few months, losing a large contract in the US, facing the resumption of the Serious Fraud Office case against it and experiencing a derating as markets deliberate over potential cuts in defence budgets.

Over the past 12 months, as the shares bounced around the 300p level, the company was hitting lows last seen in 2005; however, its recent full-year results make for pleasant reading. Most crucially for income investors, the company generated cash, and lots of it. It continues to expand both organically and through acquisition, it increased its dividend by 10 per cent and declared a £500m share buyback.

With its shares now trading on a price/earnings ratio of 8.5x, and yielding 4.8 per cent, BAE is buying its own stock back cheaply. This is not intended as a buy case for BAE Systems. However, it does illustrate the empowerment that cash gives to a business; how managers of that business must be careful stewards of that cash, and how income managers need to be adept at filtering out those companies that employ cash wisely enough to make money for shareholders. The tangible return that a shareholder gets from equity is the dividend and the growth in that dividend over time.