Stock-Picking by Free Cash Flow Yield

Richard Dahlberg knows the value of experience and a sound long-haul strategy.

Fund managers don’t come much more seasoned than Richard Dahlberg, who’s been in the industry since 1963. "You get an appreciation for cycles of exuberance and periods when people are downcast," says Dahlberg, 67, who runs Columbia Dividend Income (symbol LBSAX), a load fund, with Scott Davis.

So what stock-picking principles work over the long haul? Boston-based Dahlberg employs a dividend-growth strategy to pick stocks. He believes that companies with a habit of raising dividends regularly are more disciplined and better at allocation of capital. He says the companies he typically invests in achieve returns on equity (a measure of profitability) 20% to 25% higher than the market average.

To identify his stocks, Dahlberg screens for free cash flow yields. Free cash flow is a company’s earnings plus depreciation and other cash charges, minus the capital expenditures necessary to maintain the business. Free cash flow yield is a company’s free cash flow per share divided by its stock price. Businesses that generate robust free cash flows are capable of boosting dividends frequently.

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By focusing on free cash yields, Dahlberg avoids overpaying for the stocks. For example, he currently seeks companies with free cash flow yields well in excess of the market’s 3.5% average.

One of Columbia Dividend Income’s best performing sectors this year has been telecom stocks -- with huge gains in ATT, BellSouth and Verizon. After years of making excessive investments in the late 1990s, Dahlberg says, the industry mended its ways and focused on profitable growth. His largest holding is ExxonMobil, which despite more than doubling in price over the past four years, still yields 8.5% on a free cash flow basis. ExxonMobil’s massive free cash allows the oil giant to raise dividends and repurchase large amounts of stock simultaneously. Dahlberg also holds Altria, that perennial gusher of free cash. He applies his dividend-growth and free-cash flow analysis to selecting foreign stocks, too. He holds Britain’s Diageo, the world’s largest liquor company, and Novartis and GlaxoSmithKline, two big drug stocks, in the portfolio.

How has Dahlberg performed with this strategy? He took over a pretty mediocre fund in 2003. In fact, the fund was converted then from a value fund to a dividend-growth portfolio after a change in tax law in 2003 lowered the maximum federal tax rate on qualified dividends to 15%. Over the past three years to December 1, Columbia Dividend returned 15% annualized, beating Standard & Poor's 500-stock index by an average of 3.5 percentage points per year.

But the funny thing is that dividend-growth portfolios tend to excel in more conservative environments, not in buoyant markets like we’ve had the past few years. When the investment tide goes out, investors look for stocks with downside protection in the form of big yields and steady dividend increases. Dahlberg is one old tortoise who should beat the growth hares over the long run.

Contributing Writer, Kiplinger's Personal Finance