Stock market investing strategy for consistent dividends and cash flow

Instead of focusing on beating her benchmark, Kera Van Valen of Epoch Investment Partners has a specific target for cash returns.

Her US equity yield strategy has a mandate to deliver 9% cash returns per annum over a full market cycle from a combination of dividends, share buybacks, and free-cash-flow growth.

In an interview with Business Insider, Van Valen detailed her approach to finding companies with the greatest cash-generating potential

Van Valen also shared two stand-out companies that have helped her portfolio meet its objectives.

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Many actively managed funds live or die by how effectively they're able to outperform their benchmarks.

But that's not what Karen Van Valen of Epoch Investment Partners focuses on.

Instead, her strategy targets the heart of what every investor is chasing: steady cash flow. The Mainstage Epoch US Equity Yield Fund and its global counterpart — both of which she manages — have the very specific goal of generating 9% cash return per annum over a full market cycle.

The breakdown is as follows: Roughly two-thirds should come from a combination of cash dividends, share buybacks, and debt reduction. And the remainder should be derived from cash-flow growth.

Buying high-quality companies with strong balance sheets became a widespread recommendation last year when investors were confronted with an economic downturn caused by higher interest rates. The reasoning among many proponents was that such firms had the most dry powder to withstand higher borrowing costs.

By contrast, the lower-quality firms that binged on debt when interest rates were near zero would have struggled to meet their obligations to creditors and shareholders.

Read more: MORGAN STANLEY: 3 trends will dictate the fate of global markets for the rest of the year. Here's how to profit from each one.

Van Valen's focus on quality dates back much further, to 2005. When the sell-off ensued during the fourth quarter, her US portfolio illustrated how a focus on strong free-cash flow is a viable defense against market drawdowns. It had fully recovered from its losses by March 1 whereas its benchmark, the Russell 1000 Value index, regained its footing more than a month later. Over the past year, her US portfolio has earned an 8.5% total return versus 4.2% for the Russell index.

The 2008 financial crisis was also kinder to Van Valen's strategy, according to data compiled by Epoch Investment Partners. Her global strategy experienced a 43% US dollar drawdown, while the MSCI World Index drew down 54%.

But remember, Van Valen's focus is not on beating her benchmarks: It's all about finding companies that return cash to shareholders through recurring revenue streams.

This differentiated approach means she de-emphasizes many of the commonplace yardsticks that make for attractive investments.

“We don't feel that the traditional, accounting-based metrics are the right lenses to look through,” Van Valen told Business Insider in a phone interview.

She continued: “Free-cash flow is what we think is important. Thinking through the mindset of a CFO: How does a company generate their free cash flow？ How does a company allocate their free-cash flow？ That will ultimately determine the value of a company.”

This rationale explains why dividend yield — annual dividend as a share of stock price — is her valuation metric of choice. It's not the ratio of price to earnings, price to book value, or any of the other widely used formulas. Dividend yield falls as price rises, and so a lower yield signals to her that a company is generating more firepower to fund business ventures that will generate even more cash.

She's also on the lookout for companies that are committed to returning cash to shareholders through buybacks.

In response to the ongoing call to ban buybacks, Van Valen said it's more important for investors to understand why companies are repurchasing their shares. Not all buybacks are the same, she added: Some companies buy shares to meet an earnings-per-share target, while others do so with their cash piles as part of capital-allocation policies.

Van Valen further identified two US companies with policies that should continue to shovel cash back into the pockets of shareholders:

1) Target: We would expect that cash flow is going to continue to be driven by both their digital and store-based channels, and that we're going to continue to see square-footage growth. We think stable margins are also going to help drive long-term free-cash-flow growth.

2) Coca-Cola: “The pricing power that they have allows for 5% topline growth. They also benefit from a rebound in emerging markets, and they have made a shift to being less capital intensive and having a higher return on invested capital following their bottling divestitures.”