Tuesday, May 1, 2018

Five Tips to Avoid Dividend Cuts

Have you ever held a stock that eventually cut its dividend?

Or do you worry that a company you own might have to reduce its dividend in the future?

If so, you aren’t alone.

Most of the dividend investors I know are focused on building a safe income stream (typically for retirement) and want to preserve their capital.

Avoiding dividend cuts can help with both objectives, and in this article I will explore five techniques that can help identify companies with the best potential of delivering safe, growing dividends over time. 

But first, I want to thank Dividend Growth Investor for letting me share with you.

His blog has been an inspiration and a wealth of quality information for dividend investors for nearly a decade, and it’s an honor to be part of it today.

Let’s take a look at five of the most important factors you can use to understand the safety of a company’s dividend and make better informed investment decisions.

1. The Payout Ratio
The payout ratio is arguably one of the most important indicators of dividend safety and is also one of the most common ratios used by dividend investors.

For those who are unfamiliar, a company’s payout ratio expresses the proportion of a company’s earnings or free cash flow that is paid out as a dividend.

An earnings payout ratio of 40% indicates that a company paid 40 cents per share in dividends for every $1.00 per share that it generated in earnings over the time period being measured, for example.

The payout ratio is popular because it is a simple, straightforward assessment of dividend risk.

Companies with relatively high (e.g. above 75%) payout ratios have less margin of safety than companies with relatively low (e.g. below 25%) payout ratios, all else equal.

If a company with a high payout ratio unexpectedly sees its profits fall, it may not have enough profits left to keep paying or growing its dividend.

For most types of businesses, I like to see a payout ratio below 60% to provide a comfortable cushion for unexpected events, such as industry downturns or an economic recession.

Johnson & Johnson(JNJ) is a great example of what I like to see as a conservative dividend growth investor.

You can see below that J&J’s payout has been remarkably stable over the last decade while the company has raised its dividend by 8% annually.

Johnson & Johnson’s steady payout ratio means that most of its dividend growth was fueled by growth in its earnings (otherwise its payout ratio would have increased more substantially) and indicates that it has historically generated very predictable results.

I will selectively invest in dividend stocks with higher payout ratios if their earnings are remarkably stable.

A regulated utility company such as Duke Energy would be a good example. Its payout ratio is over 70%, but its earnings are extremely stable thanks to the quasi monopoly that exists for many public utilities. The chances of its earnings unexpectedly taking a major dip are very slim.

ConocoPhillips (COP) is an example of what I don’t like to see. The company’s payout ratio has historically been quite volatile and even negative some years, which indicates that it failed to generate a profit.

The company was not prepared for the sudden plunge in the price of oil, which caused it to report a net loss in 2015 and 2016, ultimately cutting its dividend in February 2016.

Before you think a low and stable payout ratio guarantees dividend safety, consider media company Viacom (VIA).

Viacom had increased its dividend each year since 2011 and maintained a low and steady payout ratio below 30% most years.

However, the firm still slashed its dividend by 50% in late 2016.

How could this happen? Too much debt.

2. Debt Metrics
While many companies are strongly committed to their dividends, they will always make principal and interest payments on their debt before returning capital to shareholders.

If a company has taken on too much debt and experiences an unexpected decline in cash flow, its dividend can quickly come into jeopardy.

One metric I like to look at it’s a company’s long-term debt-to-capital ratio, which essentially tells us what proportion of a company’s financing is from debt to run its business.

I prefer to own companies with a debt-to-capital ratio comfortable below 50%, but exceptions can be made for capital-intensive businesses with very predictable cash flow, such as regulated utilities.

Teva Pharmaceuticals (TEVA) provided a recent example of the dangers of debt. You can see that its long-term debt-to-capital ratio spiked from 20% in mid-2016 to 53% last quarter.

The increase in debt was due to Teva’s $40.5 billion acquisition of Actavis Generics.

The generic drug industry became even more price competitive after Teva closed this deal in August 2016, pressuring the company’s growth and ultimately forcing management to slash the firm’s dividend by 75% earlier this year to protect its stretched balance sheet.

3. Industry Characteristics
Some industries are much more suitable to paying safe, growing dividends over time.

If you look at the sector mix of the dividend aristocrats, S&P 500 companies that have paid higher dividends for at least 25 consecutive years, you will note several interesting observations.

First, you can see that the consumer staples sector accounts for approximately 25% of the dividendaristocrats index, which is significantly higher than the sector’s weight in the S&P 500.

Consumer staples businesses typically enjoy steady demand for their products because consumers always need to eat, even during recessions.

This results in very predictable cash flows that can largely be used to pay healthy, growing dividends.

On the other end of the spectrum, technology companies accounted for just 2% of the index.

Many technology firms must constantly reinvent themselves to stay relevant, which requires heavy spending on R&D to pursue numerous growth opportunities. As a result, returning capital to shareholders is a much lower priority.

Since technology trends can change more quickly than most other industries, cash flow volatility tends to be higher as well for many of these businesses, making the payment of dividends less attractive.

Companies that operate in industries with a slow pace of change, moderate capital needs, and recession-resistant end markets usually pay safer dividends, all else equal.

You can get a better feel for how attractive a company’s industry might be by reviewing how the firm performed during the financial crisis (e.g. Hormel’s sales were only down 3%, while Caterpillar’s sales fell 37%) and how consistently the business has generated free cash flow each year over the past decade (the steadier the better).

I also recommend getting to know the company well enough to understand what major changes (e.g. the cloud, changing consumer preferences, self-driving vehicles, Amazon, etc.), if any, seem likely shake up the status quo in the future.

4. Dividend Track Record
Dividend aristocrats and dividend kings are very popular with dividend growth investors because they have shown an ability to grow their payouts through all sorts of economic environment over the course of decades.

While it’s not a guarantee of dividend safety (ConocoPhillips and BHP are recent examples that come to mind), these businesses are more likely to take actions to protect the dividend “at any cost.”

The oil majors are a good example right now. Most of them have failed to generate enough cash to cover their dividends in recent years (i.e. payout ratios over 100%), but instead of reducing the dividend they have burned through cash on hand and issued fresh debt to make ends meet until the price of oil recovers.

Some of these actions, such as cutting costs too far or reducing profitable investments, can hurt long-term growth. However, paying a dependable dividend tends to attract long-term shareholders and is a signal of confidence in the business.

Focusing on companies that have never cut their dividend (especially those that have paid uninterrupted dividends over the course of many decades) can improve a portfolio’s chances of generating safe dividend income.

5. Recent Earnings Results
Almost all of the factors we have reviewed so far can signal safety, but they tend to represent a long-term, backwards-looking view of a business.

The world is always changing, and sometimes (though not often) a company that has historically paid safe dividends no longer has a reliable payout – “this time is different” actually holds true.

Looking at recent quarterly earnings results can help identify if something might have changed that merits further analysis.

Paychex (PAYX) is an example of what I like to see – stability.

You can see that the firm’s sales have grown at a steady mid-single-digit pace for the last eight quarters, suggesting that nothing has likely changed with the company’s ability to continue paying safe dividends, which it has done every year since 1988.

Macy’s (M) is on the other end of the spectrum. While Macy’s has increased its dividend each year since 2011, it’s very clear that the business is struggling to grow with eight straight quarters of year-over-year revenue declines.

Reviewing the firm’s recent results would have caused investors to really question whether or not it made sense to buy Macy’s for its dividend well before its stock declined 40%+ year-to-date in 2017.

If Macy’s cannot rejuvenate profitable growth, its dividend will likely be cut. We analyzed Macy’s dividend safety very closely in February 2017, and you can read our full report here.  

Now, not all poor quarterly results are reason to avoid buying a dividend stock or sell a holding.

Companies that pay dividends usually try to do whatever they can to continue honoring their payout, so it typically takes more than one or two weak quarters to result in a dividend cut.

Most quarterly results tend to be noise (i.e. short-term factors that don’t endanger the dividend or the company’s long-term outlook) rather than news, but unusual charts like Macy’s need to be scrutinized.

Dividend Growth Investor wrote a nice piece on how to think about slowing earnings growth in an article here. He noted there are many reasons why a company’s earnings can weaken, and it’s important to figure out what is going on.

I completely agree. In a situation like Macy’s, the key is to understand why growth has been so weak and make your best guess as to whether or not it is a temporary headwind or something more structural.

With the rise of online shopping and consumers’’ increasing preference for experiences over physical goods, I tend to think Macy’s and its dividend will continue to be in trouble, and I plan to continue avoiding the stock.

There are many other fish in the sea that have a much better chance at delivering safe dividend income and preserving capital.

Dividend Safety Scores
With most dividend portfolios holding somewhere between 20 and 100 stocks, keeping track of all this information can be complex and time-consuming.

To scratch my own itch, I created a Dividend Safety Score indicator to better assess how likely a company is to cut its dividend in the future.

Dividend Safety Scores review all of the factors mentioned above and more to help answer the question, “How safe is the current dividend payment?”

Dividend Safety Scores are available for thousands of stocks and range from 0 to 100. I recommend that conservative income investors stick with companies that score at least 60 for Dividend Safety.

I am a big believer in complete transparency, so we log every dividend cut in real-time and log each company’s Dividend Safety Score. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

The chart below plots each company’s Dividend Safety Score on the x-axis and the size of its dividend cut on the y-axis. These are the Dividend Safety Scores that were available before a company’s dividend cut was announced, providing predictive value.

Some of the biggest dividend cuts we caught in advance came from Kinder Morgan (KMI), ConocoPhillips (COP), BHP Billiton (BHP), National Oilwell Varco (NOV), Mattel (MAT), Potash (POT), StoneMor Partners (STON), Teva Pharmaceutical (TEVA), and Viacom (VIA).

You can see that all but one company cutting its dividend scored close to 40 or below for Dividend Safety, falling in the “Unsafe” and “Extremely Unsafe” buckets.

The main exception was Ecology and Environment (EEI), a micro-cap stock that scored an 82 for Dividend Safety and lowered its dividend by 17%.

The company’s fundamentals were actually very healthy, but management decided it wanted to invest more for growth, freeing up additional cash for reinvestment by reducing the dividend by 17% (read the company’s press release here).

I am not really sure there was much we could have done to flag this dividend cut ahead of time since management’s decision to reduce the dividend had little to do with the company’s actual fundamentals (e.g. payout ratios, earnings growth, balance sheet, dividend longevity etc.).

However, we do treat micro-caps with greater conservatism today in recognition of their generally more dynamic capital allocation policies.

The second observation from the chart above is that companies with lower Dividend Safety Scores were more likely to cut their dividends by larger amounts. You can see that most of the biggest dividend cuts (e.g. 50%+) happened with companies scoring below 10 for Dividend Safety.

Investors can learn more about Dividend Safety Scores, how to use them for their portfolios, and view their complete real-time track record here.

Closing Thoughts on Dividend Safety
Many dividend investors are focused on generating a safe stream of income they can live on, either today or in the future.

In today’s low-yield world, the temptation to chase yield has perhaps never been greater.

However, such a strategy can quickly lead to dividend cuts and permanent loss of capital if an investor isn’t careful.

Following some of the tips above can help give you the best chance possible to responsibly generate safe income over time.

No system is perfect since investing is largely a game of probabilities with a healthy dose of surprises and randomness, but doing some homework upfront and staying diversified can help minimize avoidable mistakes and make a nest egg last longer.

This is a guest post by Brian Bollinger from Simply Safe Dividends. Brian is a CPA and was an equity research analyst at a multibillion-dollar investment firm prior to founding Simply Safe Dividends. Simply Safe Dividends is a one-stop shop for dividend investors, providing online tools, research, and data designed to help generate safe retirement income from dividend stocks, while saving you the high fees associated with other financial products and advisors.

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