Wednesday, October 26, 2011

Why Sustainable Dividends Matter

My strategy entails purchasing dividend growth stocks which meet qualitative and quantitative entry criteria. The goal of my dividend growth portfolio is to purchase stocks that will raise dividends for years, without me having to reinvest anything back. The stream of dividend income will be used to fund my retirement, while the dividend growth will provide protection against inflation. I do not plan on selling, unless one of these three situations occur.

My strategy relies on companies which grow dividends over time. However, I do expect that I will experience dividend cuts and eliminations. Despite the fact that I own more than 40 individual stocks, a few rotten apples could lead to flat or lower dividend income for me. One of the three reasons that cause me to sell a stock is when it cuts distributions. However, I do end up replacing the cutter with a company from a similar sector, which meets my entry criteria. For example, when I sold the financial State Street (STT) in 2009, I replaced it with Aflac (AFL).

As a result, in order to reduce the risk of dividend cuts, I analyze the sustainability of the dividend payments before I commit any capital to new or existing positions. For most stocks, this means evaluating whether the dividend payout ratio is less than 60%. The dividend payout ratio is the percentage of earnings that the company distributes to shareholders in the form of dividends. Besides the absolute percentages, I also look for the trends in this ratio. In addition, I focus on the earnings and the dividend growth over the past decade, in order to assess any changes that could potentially affect the sustainability of dividend payments. Some companies increase dividends much faster than earnings, which lead to increase in the dividend payout ratio. This typically puts a limit on future dividend growth, because increasing dividends faster than earnings would lead to unsustainable payout. Thus, a clear rising trend in the payout ratio is a potential warning sign, particularly if the ratio is rising above 50%.

While I can calculate the ratio right now, once I initiate a position, I realize that things can change afterwards. A company that raises dividends faster than earnings, will eventually be in a position where it might not be able to reinvest sufficient amounts into the business. This could lead to dividend cuts, which are to be avoided. Another item to note includes structural changes. Banks such as US Bancorp (USB) and Bank of America (BAC) used to be darlings for dividend growth investors. However, the events of 2008 led to steep dividend cuts. An investor, who purchased these stocks in the 1990’s, could not have foreseen the events that led to the financial crisis of 2007 – 2009. Only those who monitored their portfolios closely and weren’t “married” to their stock holdings would have been nimble enough to dispose of the stock after the first dividend cut in 2008.

For REITs, I use Dividends to Fund From Operations (FFO) ratio, whereas for Master Limited Partnerships I use the Distributions to DCF ratio. Read more about REITs here. Read more about MLPs here.

Some recent dividend growth stocks I have purchased, that have sustainable distributions include:

Medtronic, Inc. (MDT) manufactures and sells device-based medical therapies worldwide. The company spots a dividend payout of 33.80%. This dividend champion has raised distributions for 34 years in a row and currently yields 2.90%. Check my analysis of the stock.

Walgreen Co. (WAG), together with its subsidiaries, engages in the operation of a chain of drugstores in the United States. The company spots a dividend payout of 30.60%. This dividend aristocrat has raised distributions for 36 years in a row and currently yields 2.70%. Check my analysis of the stock.

United Technologies Corporation (UTX) provides technology products and services to the building systems and aerospace industries worldwide. The company spots a dividend payout of 36%. This dividend achiever has raised distributions for 17 years in a row and currently yields 2.60%. Check my analysis of the stock.

Enterprise Products Partners L.P. (EPD) provides midstream energy services to producers and consumers of natural gas, NGLs, crude oil, refined products, and petrochemicals in North America. This master limited partnership has one of the highest distribution coverage in the MLP arena of 1.50 as of Q2 2011. Enterprise Product Partners has raised distributions for 14 years and yields 5.60%. Check my analysis of this MLP.

Full Disclosure: Long AFL, MDT, WAG, UTX, EPD

Relevant Articles:

- Four High Yield REITs for current income

This article was featured in the Carnival of Wealth

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