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The cash flow key to finding dividend income

Investors on the hunt for dividend income may want to pay more attention to cash flow.

Investors usually focus on net income and and may ask if a company’s earnings are strong enough to support its shareholder payments. But, as we have seen many times, earnings can easily be “adjusted” to look better than they are.

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Although egregious examples of fabricated earnings may quickly come to mind (Enron and WorldCom), management teams make decisions every quarter that affect what they report to the public. A far better metric to consider is a company’s cash flow, which is more difficult to manipulate.

Cash flow is a metric clients may want to consider more often as earnings are easier to manipulate.

Yet only a few of the scores of dividend-oriented passive ETFs use cash flow in selecting their holdings. These ETFs can be tricky to find: The words “cash flow” don’t usually show up in their names. In order to find them, advisors have to look at the website descriptions of the funds and frequently at the methodology of the underlying index.

Here’s a closer look at the two largest dividend-focused ETFs that employ cash flow in their screening methodology. All performance results are through Feb. 8, 2019 and are annualized for periods longer than one year.

Lisanti-Joseph-contributing-writer

FlexShares Quality Dividend Index Fund (QDF, expense ratio: 0.37%) holds 137 stocks and has $1.73 billion in assets. Based on a proprietary Northern Trust index, the fund requires holdings to pay a current dividend. Stocks are scored based on cash flow, profitability and management efficiency. Profitability metrics used can vary by industry. For example, return on assets is a worthwhile measure for industrials, but not for financials. When looking at management efficiency, the fund attempts to exclude companies with overzealous capital expenditures or aggressive merger and acquisition programs.

QDF’s largest sector positions are in technology (20.30%), financials (12.93%), and health care (11.14%). Caps are in place for individual securities, industries and sectors. The fund has a large-cap value emphasis and has had positive returns for the year-to-date (8.00%), one-year (4.18%), three-year (13.58%) and five-year (9.43%) periods. Cash flow growth for the holdings is 12.51%, according to Morningstar, which estimates QDF’s forward dividend at 3.38%.

Schwab U.S. Dividend Equity ETF (SCHD, 0.07%) has $8.5 billion in assets. Based on the Dow Jones U.S. Dividend 100 Index, SCHD’s holdings must have a minimum of 10 consecutive years of dividend payments. Candidates are scored on four equally weighted fundamental factors: cash flow/debt, return on equity, indicated dividend yield and five-year dividend growth rate. The 100 highest scoring equities are included, subject to stock and industry caps. SCHD has a large-cap value tilt and its largest sector holdings are in consumer defensive (23.73%), industrials (22.58%), and technology (17.55%). The ETF had positive results for the year-to-date (6.83%), one-year (5.91%), three-year (14.06%) and five-year (10.58%) periods. Morningstar calculates the portfolio’s cash-flow growth at 7.44% and projects its forward dividend at 3.27%.

How advisors pick between SCHD and QDF will depend upon individual preferences. Based solely on cost, the Schwab ETF is the favorite at an expense ratio of 0.07%. The FlexShares fund’s expense ratio is set to rise to 0.38% if a waiver now in effect expires on March 1. And except for the year-to-date timeframe, SCHD also has an edge in performance.

Both funds lean toward large-cap stocks, but QDF has a somewhat higher percentage of mid-cap issues. Also, QDF’s cash flow growth is higher, as is its forward dividend. SCHD’s strategy of using a 10-year dividend history and a five-year dividend growth rate can produce a more stable portfolio of payers, but it also can eliminate companies just getting started paying dividends. And when companies begin to pay dividends, they tend to increase them more substantially than firms with a longer payment history.

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