How To Find High-Quality Stocks With Big Cash Distributions

Investing in solid companies with reasonable valuations can be a simple and effective investment strategy for superior returns. Even better, if the company is distributing lots of cash to investors via dividends and buybacks, this provides an additional reason to buy the stock.

A Quantitative Strategy That Makes Sense

Dividends and buybacks say a lot about the fundamental health of a business. If management is consistently returning cash to investors, then the company is generating more cash than it needs to retain, which is a clear sign of underlying fundamental health.

But buybacks can be either value-creating or value-destroying depending on the particular case. At the end of the day, a company that repurchases stock is essentially investing in its own shares. If the stock is undervalued and business prospects are solid, then the company is investing its resources in a compelling investment, meaning its own stock.

Alternatively, if the stock is overvalued or the fundamentals are deteriorating, a stock buyback program from such a company would make things even worse for investors since the company is allocating its capital to an investment with mediocre potential.

In simple terms, if the stock is cheap and the business is solid, then the investment case is quite strong, and buybacks make the investment case even stronger.

The following strategy is an attempt to find those kinds of stocks via a combination of factors. The strategy parameters are as follows:

  • Return on Assets (ROA) has to be above 5%. This is in order to include companies that are not only generating positive earnings but also strong profitability on the company's asset base.
  • Price to free cash flow has to be below 20. The parameter is not very demanding in terms of valuation, but it's mostly intended to avoid stocks trading at excessively high prices in comparison to cash flows.
  • The company must have repurchased at least 5% of its shares outstanding in the past year. We are looking for companies that are delivering substantial reductions in the number of shares outstanding, not just repurchasing stock to compensate for the issuing of new shares.
  • Among the companies that meet the criteria above, the strategy buys the 20 stocks with the biggest amount of capital distributions via dividends and buybacks as a percentage of market capitalization.
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Disclosure: I am/we are long LRCX. I wrote this article myself, and it expresses my own opinions.

Disclaimer: I wrote this article myself, and it expresses my own opinions. I am not ...

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