Wednesday, June 19, 2013

Can a Total Shareholder Yield ETF Work?

A rare mid-week post, but earlier today I read an interesting article on Forbes about the Cambria Shareholder Yield ETF (SYLD), which was based on an interview with the Cambria CIO. So I decided to dig into the story a little this evening.

The SYLD ETF is slightly different from the growing number of dividend ETFs on the market today in that it doesn't focus solely on dividends, but also includes buybacks and debt reduction in its algorithm. From the Cambria site:
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.
It's a novel approach for sure and investors should certainly pay attention to buybacks and debt when analyzing individual companies. (I particularly liked the CIO's mention in the Forbes article about watching out for high-yielding stocks that are also increasing their share count. A good tip!)

Though I give Cambria credit for trying something different, after reading the SYLD ETF's prospectus, I'm not sure it will work as an ETF or formula-based strategy.

As we discussed in an earlier post, though buybacks are becoming a larger part of corporate distributions, I don't think a "total yield" measure can replace dividend yield.

Source: Birinyi Associates and FRB Z.1.
The obvious reason is that buybacks remain a choice rather than a commitment. In a given year or two, a company could dramatically pull back on buybacks and the "total yield" shrivels up. (It's true that a company could also cut its dividend, but this would be much harder to do given different shareholder expectations.)

To Cambria's credit, they are looking to invest in companies with a systematic approach to buybacks, but this puts enormous faith in management's ability to have a good buyback process. How Cambria measures this in its security selection algorithm is not disclosed, but it seems to be a challenging task using a strictly quantitative process.

As we've seen, many companies end up buying back stock when they have excess cash...which also tends to be when their share price is higher. In my experience, I've come across very few companies with a rational and disciplined approach to buybacks.

I'm also not clear on why debt reduction should be considered part of "shareholder yield." At face value, less debt on a balance sheet seems desirable, but it's also possible for companies to be underlevered. In this case, companies should take on more debt to reduce their overall cost of capital. Further, and more to the point, the cash return is to bondholders and not shareholders.

Perhaps the answer to the net debt reduction question lies in the prospectus, which notes that the measure of dividends, net buybacks, and net debt reduction cash flows:
"in isolation, is inadequate to determine the attractiveness of its equity securities, considered together these measures have the potential to result in the construction of a portfolio of companies with better cash flows, stronger growth potential and higher yield characteristics. Considering these measures together, which comprise shareholder yield, may result in a more attractive investment portfolio." (My emphasis)
If I were considering SYLD I would ask whether or not net debt reduction was simply a "plug" figure in the formula that made the algorithm look more predictive than dividends and net buybacks alone. Best case is the ETF is looking for firms that can return cash via dividends and buybacks without borrowing, but if that's the case, it should be more explicit in the prospectus.

I realize I've been critical of most of the new ETFs out there, but I also think it's important to look behind the alluring stories in the ETF launch material. Ultimately, I remain convinced that investors are best served building their own dividend-focused portfolio one stock at a time with thorough research.

I'm interested to hear what you think, so please let me know in the comments below or on Twitter @toddwenning.