About 10 years ago, I walked into a major bookstore here in the US looking for a book on dividend investing. I was disappointed to find only one. The lonely dividend book on the shelf was decent enough, but I was surprised at how little had been written on dividend investing relative to other strategies. Clearly it hadn’t caught on yet.
What sparked my interest in dividend investing at the time was that I’d just had first-hand experience helping portfolio managers review the accounts of some high-net-worth investors who’d put money into dividend-paying shares and had patiently held them. Decades after they’d purchased the shares, the investors were supplementing their retirement incomes with ample dividend payouts in addition to realising significant capital returns from their investments. And these weren’t celebrity fund managers generating these types of results – they were simply successful individual investors who understood the power of dividends paired with compounding growth potential.
Dividend investing surged in popularity following the financial crisis, as long-term bond yields fell sharply and the benefits of share income became more obvious. Perhaps unsurprisingly, there are now more than 300 titles available on Amazon specifically dealing with dividend investing.
The right focus
It’s great to see more attention paid to dividend investing in books and elsewhere, but a key point is still being overlooked in many books and reports on dividends that I’ve seen – that is, how to avoid dividend cuts.
This is a particularly important risk to consider today after seeing some high-profile dividend cuts in recent years. And the dividend outlook isn’t particularly rosy, either. The current edition of Capita’s Dividend Monitor publication, for example, expects just 3 per cent underlying dividend growth for the UK market in 2016. The Capita report mentions additional “risks to the downside” in its forecast if some of the market’s larger dividend payers need to cut as a result of persistently low commodity and energy prices.
As we look to grow our income streams from dividend shares, even a few cuts can have a material impact on our results. Consider that a dividend that’s been halved would need to subsequently grow by about 7 per cent per year on average for a decade just to get back to even. With this in mind, we’d do well to figure out how we might sidestep a dividend cut before it happens.
Here are 10 checklist questions to consider as you research new dividend shares or review the ones already in your portfolio.
1. Are you interested in the share for its high yield alone? One of my rules is that if a dividend yield seems too good to be true, it probably is. The market isn’t likely to give away 8 per cent-plus yields without some major strings attached, particularly in an otherwise good market like the one we have today. If buying a share with an ultra-high yield was all it took to ensure good long-term results, it stands to reason that everyone would rush to that stock to enjoy low-risk 8 per cent annual returns, which would in turn drive the stock price up and the yield down, erasing the juicy opportunity. It’s also important to remember that rarely, if ever, does a share sport an ultra-high yield due to dividend growth alone. More often it’s because the share price has fallen substantially due to investor concerns about the underlying business. The market is actually pretty good at pricing in dangerous dividends so, unless you know something about the business that most investors don’t, it’s best to stay away from a very high-yielding share until the dust has settled.
2. Does the company have a durable competitive advantage? Companies that benefit from valuable intangible assets (eg, brands and patents), low-cost production advantages, network effects (think Facebook or Uber), or switching costs may be able to defend high profit margins or high returns on invested capital from eager competitors. These durable advantages – often referred to as ‘economic moats’ – can in turn provide the company’s board with confidence to steadily raise the dividend payout over time as they will likely have more certainty that the company will be able to afford the dividend in the coming years. Companies with dwindling or no advantages whatsoever, on the other hand, often produce less dependable cash flows and therefore less dependable dividends.
3. Is the company’s balance sheet strong enough to endure a few lean years? Leverage cuts both ways – if the company is delivering on its strategy, financial leverage can improve returns to equity shareholders; if the company falls on hard times, however, debt can exacerbate the problem. Indeed, pressure from bondholders concerned about a company’s deteriorating credit profile can often lead to a dividend cut. This isn’t to say that you should limit yourself to companies with no debt whatsoever, but you should check to see that the company has the right amount of leverage given the cyclicality of its business. A mining and materials company such as Rio Tinto, for example, should all else being equal have far lower gearing than a drinks company such as Diageo. That’s because a mining company will typically have less predictable long-term demand and little control over prices, while a firm such as Diageo benefits from relatively stable demand for its products and has more pricing power due to the strength of its brands.
4. Is the company’s revenue shrinking? A company facing a diminishing top line will be more challenged to deliver profit growth unless it is able to drastically reduce expenses. And since revenue is a function of price and volume, if you have concerns about a company’s pricing power or the demand for its products in the coming years, you should also be concerned about its dividend health. This is especially true if the company also currently carries a weak balance sheet or has minimal free cash flow cover, as additional stress on profits could be enough for the board to re-evaluate the dividend policy. Look for companies with five-year annualised revenue growth of 2-3 per cent at minimum.
5. Has the dividend growth markedly slowed in recent years? A distinguished track record of dividend growth is usually a positive signal that the company is dedicated to sharing its success with shareholders and that its prospects are improving. However, if the company’s dividend growth rate has slowed materially in recent years or if the dividend has been held flat on a year-on-year basis, it could be a sign that the board and management are concerned about the company’s ability to pay the dividend going forward. This happened at Tesco leading up to its eventual dividend cut and proved to be a proverbial canary in the coal mine. Prior to the cut, Tesco increased its dividend at a good pace for over 20 consecutive years until 2012 when it sharply hit the brakes on dividend growth. A measured decline in the dividend growth rate should be expected as a company matures, but be cautious when there’s a marked shift in the pace of growth as it could be a sign of trouble ahead.
6. Has the company consistently covered its dividend with ample amounts of free cash flow? When investors hear the phrase ‘dividend cover’ they often think of earnings cover; however, I find it much more instructive to focus on free cash flow cover (cash from operations minus capital expenditures divided by gross dividends paid) because earnings, as the old saying goes, are an opinion while cash is fact. And since we’re concerned with the stability and growth potential of cash dividends, I find free cash flow cover, which tells us how much cash a company’s operations have generated after reinvestment, a more appropriate metric than earnings cover.
7. Free cash flow cover can be thought of as your dividend ‘margin of safety’ or ‘margin of error’. All else being equal, the higher the ratio, the more secure you might consider the current payout and the more likely the dividend can grow in the future. Conversely, a company with a free cash flow coverage ratio near or below one times has very little margin for error if it aims to maintain its current dividend. If it falls on a rough year, the dividend might be on the chopping block. A company with low or non-existent free cash flow cover could support the payout for a while using alternative financing (borrowing, selling assets, etc), but that’s an unsustainable solution. Eventually, the company will need to generate free cash flow from operations to support the dividend.
8. A good rule of thumb is to look for free cash flow cover above 1.5 times. As with any rule, there are exceptions and much will depend on the company’s stage in its life cycle and the stability of its business. A smaller company that’s still reinvesting large amounts in the business may have a very high free cash flow cover while a regulated utility company might reasonably pay out close to all of its free cash flow each year. Similarly, a cyclical company may exhibit very high free cash flow cover near the peak of its cycle, so it can help to consider trends in a company’s free cash flow cover over time.
9. Is management’s incentive structure aligned with shareholders’ interests? As you read through a company’s annual report, it’s easy to gloss over the board’s remuneration report that details management’s pay package, but therein often lies important insight into what motivates management. Dividend investors ideally want to see management’s bonus metrics tied to factors with a direct impact on dividend sustainability and growth potential, such as free cash flow generation, balance sheet health, and improving returns on invested capital. Earnings per share is a more common metric used in incentive schemes and it also has an impact on dividend health, but as noted above free cash flow is the more direct measure. I’m less enthusiastic when I see management heavily incentivised on metrics like Ebitda or revenue as they are further removed from the real cash flows available to shareholders. Also look to see if management and the board members themselves own a significant amount of shares. If they have ‘skin in the game’, they’ll feel the sting of a dividend cut along with shareholders and will therefore likely be more conscious of remedying poor dividend health before things turn south.
10. How does management return cash beyond what it needs for the regular dividend? A company that more than covers its regular dividend with free cash flow will naturally have extra cash to use for saving, spending on acquisitions, paying down debt, or repurchasing stock. This is a good problem to have, but how the company allocates that extra capital can have important implications for dividend investors. If the company uses the extra cash to buy back shares at expensive prices, for example, it will erode shareholder value over time. On the other hand, if the company has a good buyback strategy and consistently repurchases shares at good-to-fair prices, it can enhance shareholder value over time.
Next (NXT), for example, has a well-defined buyback strategy that seems to have created long-term shareholder value and has also supported its dividend growth due to the fact that the company can spread its payout over fewer shares outstanding. I particularly like to see dividend-paying companies in cyclical industries pay small ‘regular’ dividends and pay additional ‘special’ dividends in good years when they’re flush with cash, as this reduces the risk that management will repurchase stock or make an acquisition when valuations are high. A company that follows this strategy is Rotork (ROR), which has paid special dividends to shareholders in six of the past 11 years in addition to steadily raising its regular dividend.
How does the company’s yield compare to its competitors? When I bought shares in US pharmaceutical giant Pfizer (US:PFE) in July 2008, it had a trailing yield near 7 per cent, which at the time was anywhere from one to two full percentage points above its major peers. However, I thought that because the company had a then AAA-rated balance sheet, a track record of increasing dividends for over 40 consecutive years (including a recent 10 per cent increase), and was in a defensive industry that it would be able to maintain its payout, despite increasing pressures from generic competition and Pfizer’s ongoing business transformation.
Boy, was I wrong. A few months later in January 2009 in the midst of the financial crisis, Pfizer decided to slash its once-sacred dividend in half when it acquired fellow drug giant Wyeth. Pfizer raised plenty of debt to help fund the deal, but it noted in its press release announcing the dividend cut that the new yield remained “competitive with other industry participants”. In other words, while Pfizer most likely could have financially maintained its payout, it seems to me that at least part of the motivation for the cut was that Pfizer’s board thought that it was paying out too much relative to other companies in its peer group. This was a very valuable lesson to learn, even if I learnt it the hard way. Companies can be quite content with having a higher yield than peers, of course, but take note if other business factors are weak or if the company’s yield is approaching high single digits, because the company’s board may see an opportunity to rebase its payout as a means to save cash and invest in new strategy initiatives.
Does the company have the right dividend policy? All else equal, companies in cyclical or capital-intensive businesses should have higher dividend coverage ratios than companies in defensive or asset-light businesses. Companies in commodity-driven industries can get in trouble when they raise the dividend too quickly in good times, only to have to cut the dividend when the cycle turns against them. The ideal dividend policy should take this factor into account in addition to the company’s reinvestment opportunities. If the company has plenty of opportunities to reinvest in value-enhancing projects, for example, it should pay out less of its cash flows than a more mature company with limited reinvestment opportunities.
Bottom line
Being vigilant about the health of the dividend-paying shares we’ve assembled in our portfolios can help us avoid dividend cuts that can impair our long-term income streams. By asking the above checklist questions and considering our conclusions on them, we can give ourselves a better chance of picking up on shaky dividends before things go from bad to worse.
Todd Wenning, CFA, is an equity analyst based in the US
