Our investment strategy reflects the changing hierarchy of the three determinants of equity investment returns: earnings, dividends, and P/E multiples.
Over time, the relative importance of these three determinants has changed dramatically in response to changes in the economic landscape. In the 1980s and 1990s, for example, rising P/E ratios were the principal drivers of equity returns, leading to the popularity of valuation methodologies that reflected price-to-book value and price-to-earnings metrics. Underlying this 20-year P/E expansion was a collapse in interest rates. Beginning in June 2003, however, this two-decade period of declining interest rates and expanding P/E ratios showed signs of coming to an end. We believe we have entered a period in which P/E ratios are more likely to contract than expand as interest rates begin to rise rather than fall from recent historic lows. Given the inverse relationship of P/E ratios to interest rates, the expansion of P/E multiples will no longer be the primary explanatory variable of equity returns. This leaves earnings growth and dividends, the two variables that have been the dominant sources of equity returns over the past 80 years. These two variables are derived from a single source: cash flow.
A Focus on Cash Flow
Epoch’s security selection process is thus focused on free-cash-flow metrics as opposed to traditional accounting-based metrics. In our view, the key to producing superior risk-adjusted equity returns is the identification of companies with a consistent ability to both generate free cash flow and to properly allocate it among internal reinvestment opportunities, acquisitions, dividends, share repurchases and debt repayments. The determination of how to deploy free cash flow should be guided by the company’s cost of capital. Acquisitions and reinvestments should only be undertaken when the return on capital is greater than the firm’s average cost of capital. Otherwise, free cash flow should be returned to shareholders via the other three uses: dividends, share buybacks and debt repayments. Epoch defines these three uses of free cash flow as “Shareholder Yield.”
Before making an investment, we analyze a company as if we were looking to purchase the entire business. We invest in businesses with understandable operating models, transparent financial statements, and a proven ability to generate free cash flow. We also seek securities that, in our view, have unrecognized potential. Risk controls are integrated in both the security selection and portfolio construction process in order to manage aggregation risk exposures and increase the efficiency of the portfolio in terms of risk versus reward.