Cholwill, manager of the five crown-rated Royal London UK Equity Income fund, says because he is looking for companies with sustainable dividends that can grow over time, he needs to know the company has cash coming through on the books to back that up.“For me a key measure of value is cash-flow,” he said.
“I think, particularly since the credit crunch, we’re in a world of anaemic growth and therefore those companies which can offer sustainable growth are much more valuable than perhaps pre-credit crunch when growth was much more widely available.”
“A measure of sustainable dividends is all about looking at cash-flow. I think you need to look at cash-flow rather than profits because profits can be much more susceptible to creative accounting.”
“I just take the simple view that if profits don’t convert to cash then those profits aren’t worth anything.”
In the midst of reporting season, when a number of UK companies release their half-year and full year results as well as expectations for the future, this is especially apt.
More companies issued profit warnings in the final quarter of 2013 than at any time since the darkest days of 2008. This has continued into this year, with the likes of FTSE 100 giants Diageo and Rolls Royce issuing negative news.
Performance of stocks vs index in 2014
Source: FE Analytics
However, Cholwill says the savvy investor can steer clear of value traps by looking at the cash-flows.
“If you focus on cash-flow, that to me is what it’s about,” he said.
The manager adds that ensuring there is plenty of liquidity in a company can also insulate investors who are in need of a steady, reliable income against dividend cuts.
“If you look at those companies that cut their dividend, often it’s not just a 5 or 10 per cent trim, often it’s much more major than that, with companies often stopping paying dividends altogether,” he warned.
Cholwill says one reason companies have poor cash positions is that they’re in debt.
“Often a coinciding factor is companies are rather too indebted. And the reason of course companies become indebted is because they aren’t generating enough cash-flow,” he said.
“If they generated the cash-flow then they wouldn’t have the debt on their balance sheet.”
“It goes hand in hand,” he added.
“Clearly, when you look at share price performance of those that cut their dividend heavily, often you see a period of share price weakness post that period. It’s not always just about picking the winners, it’s about avoiding the losers as well.”
While Cholwill doesn’t consider himself an all-out contrarian investor, he says there is a degree of going against the herd when investing in equities as he aims to pick up stocks as cheaply as possible.
“I would describe myself as very much a traditional investor. Essentially I look to buy good companies when they’re out of favour or out of fashion and therefore you’re able to buy them on a decent dividend yield,” he said.
According to previous FE Trustnet research, Cholwill’s Royal London UK Equity Income fund is the most consistent performer in the entire IMA UK Equity Income sector over the last five calendar years.
The manager has continued his outperformance in the volatile early months of 2014, delivering 3.55 per cent so far.
The sector has gained 2.68 per cent while the FTSE All Share has made just 1.64 per cent.
Source: FE Analytics
The portfolio has made 141.56 per cent since Cholwill took over in March 2005, well ahead of both the sector and index, which gained 92.66 per cent and 99.48 per cent, respectively.
Performance of fund vs sector and index since 2005
Source: FE Analytics
The manager says he would consider the fund very much a core UK equity income holding.
Royal London UK Equity Income has a yield of 3.48 per cent, which puts it in the lower half of the sector in terms of dividend payouts; however, it has a higher yield than the likes of other core equity income holdings such as the Invesco Perpetual Income and High Income funds.
Cholwill holds a large chunk of the £909.6m portfolio in large cap stocks, including UK bank HSBC, oil giants Royal Dutch Shell and BP and pharmaceutical behemoths GlaxoSmithKline and AstraZeneca.
However, it is more heavily invested in mid caps than the majority of its peers.
It is also a member of the FE Select 100 list of elite funds.
FE analysts say that the fund’s mid cap exposure means the portfolio is likely to outperform in rising markets and underperform in falling ones.
The fund is equally weighted between industrial and financial stocks as the largest sector bets, with roughly 26 per cent of assets in each.
A number of multi-managers are backing Royal London UK Equity Income, including FE Alpha Manager trio John Chatfeild-Roberts, Algy Smith-Maxwell and Peter Lawery in their Jupiter Merlin Balanced fund.
The fund requires a minimum investment of £1,000 and has ongoing charges of 1.28 per cent.
