Brent Sheather: Smart to push value of dividends to funds

NZX chief executive Mark Weldon. Photo / Mark Mitchell

Reading the finance pages of late we have seen big-hitters like Mark Weldon of the NZX and Carmel Fisher of Fisher Funds stressing the importance of free cashflow and dividends in assessing the value of an investment.

Free cashflow is roughly equal to the profits of a company plus its depreciation charge, less capital expenditure required to maintain the company's assets, and dividends are usually that part of the free cashflow that is paid out to shareholders.

Free cashflow is a particularly important variable as it is used in discounted cashflow models to calculate the economic value of a company.

When calculating free cashflow, it is critical to differentiate between operating and extraordinary profits. For example, a company making widgets may sell a building for a profit, but this is clearly an extraordinary profit and not a recurring cashflow stream.

In the UK, home of investment trusts, some of which have been going for more than 100 years, the convention when looking at managed funds is to study trust operating profits - that is, dividends and interest received by the fund, less the cost of running the fund.

Old established managed funds like the UK and New Zealand-listed investment trust City of London always quote their long-term record of increasing dividends relative to inflation, vital information for prospective investors as a key objective when retired is making sure your income keeps up with your expenses.

So in the context of an investment strategy for mum and dad investors, this is good advice from Weldon and Fisher. But as is so often the case, dig a bit deeper and irony is not so very far away.

Weldon's advocacy of the importance of free cashflow may seem a little ironic to shareholders of the Smartshares range of low-cost passive funds managed by the NZX as neither the dividend yield of these funds nor their long-term success or otherwise in respect of growing dividends faster than inflation is illustrated in the funds' fact sheets.

Sure, the data is there in the annual reports, but anecdotal evidence suggests that not many shareholders actually see this information as they have to ask for it and, at 89 pages, it is a reasonably imposing document. Smartshares may be a smart investment; however, the marketing needs to be improved.

Smartshares' fact sheets are a missed marketing opportunity, which is a great pity because, as the name suggests, they are smart investments relative to what else is on offer locally.

I showed the fact sheets of the TeNZ and Midcap funds to two shareholders - my wife and my mother - and asked for their comments

These fact sheets feature a downward sloping graph, which is the capital performance of the funds for five years. My wife asked why we were investing in these funds when they had performed so badly over the past five years, so I had to explain that, inexplicably, the graphs excluded dividends and, with dividend yields of around 6 to 7 per cent a year, the total-return performance looked much better.

Both said they felt worse about Smartshares after looking at the fact sheets.

Unlike standard practice in the UK, there is no profit or dividend data on a per share basis, the dividend yield isn't calculated and, for goodness sake, the performance graph materially understates performance by excluding dividends.

This is vital information, so it is no wonder that, while the rest of the investment world is embracing exchange-traded funds and piling into them, investment in the TeNZ, MDZ and FNZ funds has increased by just 15 per cent over five years.

This is an indictment of the NZX, owner of the Smartshares brand, and particularly unfortunate for New Zealanders, as exchange-traded funds make as much sense for individuals as they do for institutions.

I spoke to Deborah Fuhr, managing director and global head of ETF research and implementation strategy for BlackRock (which owns the i-Shares range of ETFs) and she estimated there were, as at December 2010, US$1.5 trillion ($1.85 trillion) invested in exchange-traded funds worldwide, more than three times the sum of five years ago. The directors of the Smartshares funds need to get themselves a copy of the fact sheet for City of London.

In contrast to Smartshares, the management of Fisher Funds has been very successful in marketing its products despite higher fees.

Carmel Fisher, who owns Fisher Funds, recently wrote highlighting the high level of dividends available from New Zealand companies. New Zealand dividends are much higher than those in the rest of the world and, if we look at Fisher Funds-listed company Kingfish, sure enough, the dividend yield is an impressive 8.7 per cent, tax-free.

That's equivalent to about 12.4 per cent pre-tax, which sounds unbelievable, and sure enough, it's not quite the whole story.

As noted earlier the convention in the UK and among the biggest listed investment companies in Australia is to pay out operating profits - dividends received less the costs of running the company. Capital gains are retained within the company.

This mirrors what generally happens in the corporate world. When Trustpower's hydro-generation assets go up in value, for instance, it doesn't sell them and pay out the cash as dividends.

In two weeks' we will look at how Kingfish manages to pay its high dividend and compare its operating profits per share with those of its closest exchange-traded fund equivalent, the Midcap Index Fund.

Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge. Sheather and clients own shares in the SmartTeNZ, SmartMDZ and Kingfish funds.