Domestic Equity—Value | January 2014

Companies that return cash to shareholders seem poised for strong performance

By James M. Tringas, CFA, CPA; Bryant VanCronkhite, CFA, CPA—Portfolio Managers, Wells Fargo Advantage Special Mid Cap Value Fund

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In recent years, stocks have appreciated, in part, because companies have returned cash to shareholders via increased dividends and share buybacks. According to Standard & Poor’s, for example, S&P 500 stock repurchases increased from approximately $24 billion in the second quarter of 2009 to $118 billion in the second quarter of 2013. During that same period, dividends paid increased 60%, from $48 billion to $77 billion.

Going into 2014, we expect that companies will continue using strong cash flows, solid balance sheets, and access to low-cost debt to fund buybacks, dividends, and merger and acquisition (M&A) activity. Because our investment process focuses on finding companies with the ability to employ balance sheet strength and free cash flow, as exemplified by commercial lender CapitalSource Incorporated, we believe that we could benefit from the continuation of these corporate actions.

An emphasis on strong balance sheets and cash-flow generation
The essence of our investment strategy is to identify and invest in companies with increasing cash flows and flexible balance sheets that offer attractive reward to risk. Both portfolio managers are certified public accountants, and our accounting-based approach allows us to find hidden risk and value by giving us a deeper understanding of how accounting estimates, assumptions, and rules affect long-term free cash flow.

Our investment in CapitalSource is a good example of our process. We purchased CapitalSource in the second half of 2009 when its share price was depressed because of the financial crisis. As a commercial lender, CapitalSource needs continuous access to short-term financing so that it can make loans to its customers; the company then typically refinances its short-term debt. Because of the credit crisis of 2008 and 2009, CapitalSource was unable to refinance short-term debt and was in danger of bankruptcy. However, the company worked with its lending group to refinance a portion of its debt and to waive some debt covenants. At that point, we became interested because we saw a path toward getting the rest of the debt refinanced, thereby strengthening the company’s balance sheet.

Chart 1: CapitalSource’s debt-to-equity ratio rapidly improved during our holding period, to the point where the company became an attractive acquisition target.
CapitalSource’s debt-to-equity ratio rapidly improved during our holding period, to the point where the company became an attractive acquisition target.
Source: Bloomberg
Past performance is no guarantee of future results. This chart is for illustration only and does not predict or guarantee the performance of any Wells Fargo Advantage Fund.

During the time that we owned CapitalSource, the company took several steps to strengthen its balance sheet, including selling some health care properties in the fourth quarter of 2009, writing down debt, and accelerating loan-loss provisions. As CapitalSource’s balance sheet strengthened, it gained the flexibility to return cash to shareholders through share repurchases and by paying a $0.50 per-share special dividend in 2012 (see Chart 2). Due to CapitalSource’s overall financial improvement, in late 2013 PacWest Bancorp agreed to purchase CapitalSource at a premium to its closing price prior to the deal’s announcement.

Chart 2: CapitalSource reduced its outstanding shares during our holding period and also paid a special dividend.
CapitalSource reduced its outstanding shares during our holding period and also paid a special dividend.
Source: Bloomberg
Past performance is no guarantee of future results. This chart is for illustration only and does not predict or guarantee the performance of any Wells Fargo Advantage Fund.

Concluding observations

In the current slow-growth environment, we believe companies that can grow their cash flows organically or that have the ability to add debt to underleveraged balance sheets will continue to boost share buybacks, increase dividends, or participate in M&A activity. Because our process leads us to emphasize cash-flow-rich companies with strong balance sheets, we believe the fund is well positioned to benefit from such shareholderfriendly corporate actions.

Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Smaller-company stocks tend to be more volatile and less liquid than those of larger companies. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk. Consult the fund’s prospectus for additional information on these and other risks.

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