Assure Your Entity Has Growing, Spendable Cash Flow, Regardless Of The Economy

By Norman Barnett

Whether you are the trustee of a company’s pension fund or an organization’s endowment fund, you want to ensure it has the cash flow from your entity’s investment portfolio to fulfill its mission. Most pension and endowment fund trustees are aware of the impact inflation has on their entity’s expenses, but few are aware of the opportunity they have to influence the degree to which their portfolios give them the growing cash flow they need to offset inflation, despite market volatility and low interest rates.

Simply stated, inflation is the measure of how much the things we buy increase in cost each year. During the past 30+ years, the inflation rate in the United States has ranged from less than 2% to more than 15%, with an average of more than 3.7% per year, compounded. That means that, with few exceptions, the cost to buy the things the entity needs to function goes up consistently.

Despite this fact, trustees hear relatively little about their needing to plan for inflation. That is unfortunate because having inflation is actually U.S. government policy. In other words, you must plan to spend more for the things you need to keep your organization running (utilities, employees, supplies, etc.), and at least make the payments you are obligated to make..

Here’s an example of how quickly inflation can eat away at an organization’s cash flow. If your entity has $300,000 in income today ($300,000 of purchasing power), and the inflation rate stays consistent at 3% per year, in 10 years you’d need more than $400,000 in income to have the same purchasing power you do today. In 20 years, assuming the same 3% per year inflation rate, you’d need more than $500,000 in income just to maintain your current purchasing power.

The fact is that today’s low interest rates on money market funds, savings accounts, and bonds, along with the stock market’s low yield, force many organizations to spend their capital. Clearly, this is a real problem, because once the capital is gone, there is no pension or endowment fund.

Investing for Growth-of-Income: If you’d like a proven way to gain generous, growing, spendable income from your entity’s investments—so you only spend the growing income each year and don’t invade capital—consider the following process:

• Put some “requirements” in place for your investment manager: As a trustee, you may not be managing the entity’s investments personally; however, you can have requirements in place for your investment manager. Whether you state the requirements verbally or as a formal written objective is up to you. While you wouldn’t necessarily tell the investment manager which specific investments to choose, you can set forth as a primary objective that you want him or her to manage for growing income so the entity is optimizing growth of cash flow. After all, your Board of Trustees is obliged to give your investment manager instructions with respect to what they would like him or her to accomplish.

• For growing income, require that your investment manager invest only in the stocks of companies that have at least 10 years of never-decreasing dividends and higher than average yields: Only common stocks, among marketable securities, can give an investor growing income. While you may think that finding any company with a track record of 10 years of never-decreasing dividends is like finding a needle in a haystack, the fact is that hundreds of companies meet this criterion. The Yahoo Finance Stock Research Center website has a Historical Quotes feature that lets you see a company’s dividend history. Looking back 10 years is long enough to make certain that the company’s management values paying increasing dividends.

• Require that your investment manager’s researchers do the necessary homework on companies to invest in: Investing wisely requires some investigative process. Therefore, make sure your investment manager’s researchers read the Chairman’s Letter to Shareholders in the annual report each year and look at the company’s revenue history, earnings history, earnings per share history, and dividends per share history. These vital indicators reveal the company’s overall health. For example, if you see that a company is increasing their dividends by 11% per year, on the surface that sounds promising. With some more investigation, though, you may find that the company’s revenue is growing by only 2% each year. Earnings growth ultimately has to come from revenue growth. Companies can cut costs for a while to grow earnings, but if they cut back costs too much, the changes will become apparent to customers and they’ll lose business. Therefore, it’s an unsustainable model and a company you’d want to avoid.

• Require that your investment manager choose as investments those companies that appear likely to have dividend growth that will give you the highest yield in five years: Many people who choose investments make a guesstimate of what the company’s future earnings per share is likely to be. But they don’t go to the next step to estimate what the company’s dividend appears likely to be in the future. Without this information, it’s difficult to invest for growing income wisely. Therefore, in addition to their fundamental research, instruct your investment manager to seek input from a company’s Chairman of the Board regarding what he or she feels the board will want the dividend payout ratio to be in five years, based upon what the company has done historically. Then apply the Chairman’s estimate of the company’s payout ratio in five years to analysts’ estimated earnings per share growth for five years to arrive at an estimate of the company’s dividend in five years. Is this 100% accurate? Of course not. No one can predict the future. But if you’re choosing companies that have paid dividends for the past 10 years or more and have consistent revenue growth, it is highly probable that the company’s management is forecasting and planning to the best of their ability.

• Require that your investment manager document portfolio changes: Whenever your investment manager changes a portfolio position, require that he or she documents what effect changing that position has on both the income it generates and on the position’s estimated growth rate of dividends. These two factors directly affect the income your entity will get now and in the future. Ideally, your entity’s portfolio will have ten positions—meaning you’ll own ten stocks where 10% of the portfolio value is invested in each position. There are only two instances when selling something is justified: 1) when the company cuts their dividend payment, as now they no longer qualify as a company with never-decreasing dividends, or 2) when your investment manager assesses the marketplace and identifies another company that is a better prospect in terms of having a higher projected yield in five years, with the same or higher current yield.

• To ensure that your capital continues to grow, plan to spend the income on your investments and avoid spending your capital: If you think that taking only $200,000 from your capital each year is not a big deal, think again. Reverse compounding works just like compounding does…but in reverse. For example, suppose you have $5 million in capital invested in a Blue Chip stock portfolio. Unfortunately, the market stays flat or goes down. Your dividend income from your investment might only be $100,000 (2%) per year. But you need $300,000 to support your entity’s mission or obligations. So you sell $200,000 worth of your stocks (4% of the portfolio’s value). Now you have less capital producing dividend income, so your dividend income next year might well be less than $100,000, and you have to sell more than $200,000 of your portfolio. When you withdraw more than you’re earning, the percentage you’re withdrawing keeps going up. It is a reverse compounding process, where your market value shrinks at an increasing rate.

Create Generous, Growing Investment Income for Your Organization: With many pension funds underfunded, and with many endowed organizations struggling to support their mission with their endowments, investing with a growth-of-income focus is imperative. Ultimately, when you implement these suggestions for your entity’s investments, you can have growing income for life, regardless of what the stock market or interest rates do.

Read other articles and learn more about Norman Barnett.

[This article is available at no-cost, on a non-exclusive basis.  Contact PR/PR at 407-299-6128 for details.]