Page 12 - DIY Investor Magazine - Issue 23

WHY CASH FLOW KEEPS YOU ON THE STRAIGHT AND NARROW
Job Curtis, Fund Manager of the City of London Investment Trust, explains why cash flow is so important when investing in equities for the purpose of income, using two stock case studies.
Estimating a company’s future cash flows is a common method of share price valuation. For investors seeking dividend income from shares, cash flow is crucial.
In our view, successful income investing involves identifying companies with enough cash flow not only to pay their dividend, but also invest enough to generate future profit growth.
While it is possible to grow a dividend with debt, this is unlikely to lead to sustainable dividend growth and will leave a company poorly placed for a cyclical downturn. A company with a heavy burden of debt facing falling demand for its goods and services, leading to reduced profits, will inevitably prioritise interest payments to service its debt. Such an indebted company is more likely to cut its dividend compared with a company that has no debt or a low level of borrowings.
‘FOR INVESTORS SEEKING DIVIDEND INCOME FROM SHARES, CASH FLOW IS CRUCIAL’
To illustrate some of the complexities in understanding cash flows and dividend sustainability, the oil sector offers a useful example.
Royal Dutch Shell (RDS) is the largest company by market capitalisation listed on the London Stock Exchange and BP is the fourth largest. RDS has one of the best dividend records of any company having not cut its dividend since the Second World War. BP’s record is more volatile over the long term and it had to suspend
its dividend for six months in 2010 after the Macondo oil spill tragedy in the Gulf of Mexico.
The key determinant of cash flow for RDS and BP in the short term is the oil price, which will affect the profitability of their oil fields that are in production. It also has a
significant bearing on their large natural gas businesses where long-term contracts continue to have high linkage to the oil price.
The chart below compares the oil price over the last 10 years with the total return from the shares of RDS and BP and overall indicates a fairly close correlation as well as showing the companies have responded well to the lower oil price environment since 2015.
FIGURE 1
Both companies also have large ‘downstream’ operations, which encompass chemicals, refining and marketing (such as petrol stations). In general, these downstream operations are counter-cyclical and RDS and BP are able to earn a better profit margin on them during oil price downturns.
A further feature to consider when predicting cash flow for both companies is their level of investment. Oil fields deplete and therefore it is necessary to replace production by investing in new fields.
During the oil price boom of 2005-2011, the industry invested heavily, pushing costs higher leading to disappointing profitability despite the supportive oil price environment. Since 2014, both companies have been much more disciplined on capital expenditure although this leads to some questioning whether they are investing enough for the future.
DIY Investor Magazine | Oct 2019 12