If You Like Dividends You Will Love This Strategy

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investing in dividend stocks is a smart, time-proven investment strategy. However, dividends are only one of the different ways in which companies can distribute free cash flow to investors. Shareholder yield, which includes dividends plus stock buybacks and debt paydown, is a more comprehensive approach and is worth some serious consideration when trying to find the best investment opportunities.

Beyond Dividends

Dividends are great, not only because they provide income and a stable source of returns for investors, but also because they reflect a company´s ability to consistently generate free cash flows. On the other hand, there is much more to free cash flows than dividend payments.

Over the last years, due in part to tax considerations, many companies have chosen to distribute a growing proportion of their cash flows via stock buybacks in detriment of dividend payments. Capital gains are taxed at lower rates than dividends for most investors, so the shift in capital distribution policy makes a lot of sense and will likely remain in place as long as the tax structure stays the same. By focusing solely on dividends, investors may be missing buybacks, which represent an increasingly bigger part of capital distributions.

Another way in which companies can use their free cash flows is by paying down debt. Depending on the particular company and its circumstances, issuing or paying down debt may be the right thing to do. Still, by including debt into the equation, shareholder yield eliminates those risky situations in which companies are financing dividends and buybacks via debt emissions as opposed to genuine cash flow generation.

According to research by Mebane Faber, co-founder and Chief Investment Officer of Cambria Investment Management, focusing on companies with high shareholder yields – dividends plus share repurchases and debt paydowns – provides better returns than selecting stocks based on dividend yields alone.

The recently issued Cambria Shareholder Yield (NYSEMKT: SYLD) ETF provides an interesting alternative for investors looking to invest in companies with high shareholder yields. The fund charges a 0.59% expense ratio and, according to the prospectus:

The Cambria Shareholder Yield ETF is an actively managed fund that employs the manager's quantitative algorithm to select U.S. listed companies that show strong characteristics in returning free cash flow to their shareholders. Specifically, SYLD invests in 100 stocks with market caps greater than $200 million that rank among the highest in (a) paying cash dividends, (b) engaging in net share repurchases, and (c) paying down debt on their balance sheets.

The fund is barely one month old, so it doesn´t have a long enough track record to analyze in depth. It is however based on smart investment principles and sound research, so it is definitely an alternative to keep in mind.

Specific Companies

For investors preferring specific companies, some of the fund´s holdings look particularly attractive.

American Express (NYSE: AXP) owns an undisputed leadership position in the global credit card industry. The company´s brand presence and proprietary data networks provide rock-solid competitive advantages for this financial giant. In addition to that, its affluent customer base means more profitability for American Express versus its peers.

The company plans to repurchase up to $4.2 billion in shares over the next twelve months, which means nearly 4.9% of the current market value. The recently increased quarterly dividend of $0.23 adds another 1.2% to shareholder yield, and American Express has been steadily reducing debt over the last years.

<img alt="" src="http://g.fool.com/editorial/images/57861/axp_debt_large.png" />

Another financial juggernaut in the portfolio is AIG (NYSE: AIG). The company has come a long way in terms of reducing debt since the financial crisis, and shares outstanding have been falling steeply due to generous buybacks over the last couple of years. AIG pays no dividends, but that may change sooner rather than later now that the company is in a much better financial shape and free from any government ownership.

<img alt="" src="http://g.fool.com/editorial/images/57861/aig_debt_large.png" />

<img alt="" src="http://g.fool.com/editorial/images/57861/aig_buybacks_large.png" />

Besides, the business is clearly improving. The company reported earnings figures well above analysts’ expectations for the last quarter: overall insurance operating income was up 28% from the same quarter last year, and book value per share, excluding accumulated other comprehensive income (AOCI), increased by 12% in comparison to the first quarter of 2012. At a price to book value ratio of 0.68 the stock is offering substantial value too.

Thanks to the popularity of brands like Gap, Old Navy, Banana Republic, Piperlime, and Athleta, GAP (NYSE: GPS) has become one of the most successful players in the clothing retail industry. The business is firing on all cylinders; GAP recently reported a big 7% increase in same store sales for the month of June, materially above analyst’s expectations of 4.7%.

The dividend yield of 1.3% may not sound very impressive, but when you consider a buyback program of $1 billion announced in January - more than 4.7% of current market cap - and a consistent debt reduction policy over the last few years, things become much more interesting in terms of shareholder yield.

<img alt="" src="http://g.fool.com/editorial/images/57861/gps_large.png" />

Bottom Line

Everybody loves dividends, and for good reasons. However, shareholder yield provides a more comprehensive and holistic approach to capital distributions. When analyzing capital distributions, investors should broaden their scope to include companies with big buybacks and debt paydowns in order to make the most out of their investments.

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Andrés Cardenal owns shares of AIG The Motley Fool recommends American Express and American International Group. The Motley Fool owns shares of American International Group and has the following options: Long Jan 2014 $25 Calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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