How to avoid dividend cuts
In order to reduce the chance of dividend cuts, the investor needs to focus on several key metrics:
1) Dividend Payout Ratio
The dividend payout ratio is calculated by dividing the annual dividend income over earnings per share. In other words, this is the portion of earnings which are distributed to shareholders in the form of dividends. A lower number is usually better, because it allows for a better margin of safety on the dividend stream from earnings. The margin of safety is helpful when earnings decrease in the short run, due to a soft economy for example. Companies that have ample room for maneuvering can continue paying and even increasing those dividends when earnings are temporarily down and the payout ratio temporarily spikes up.
In my analysis, I look for a payout ratio that is less than 60%. I also look at the trends in the dividend payout ratio, in order to see if it is growing or decreasing. I do not want to see companies that grow the dividend by expanding the payout ratio. I want companies to grow the dividend, while keeping the payout ratio around a range and keeping a lid on the payout ratio.
However, certain companies in certain industries can afford to pay higher portions of their earnings to shareholders. Many utilities for example tend to distribute over 60% - 70% and even 80% of their earnings to shareholders in the form of dividends. These companies are regulated monopolists, which tend to generate stable earnings and revenues over time. Due to this stability of the business model, they can afford to have high payout ratios. The dividend analyst can usually evaluate the sustainability of the dividend by reviewing the trends in the payout ratio. A public utility that has paid between 70% and 80% of earnings as dividends over the past decade has a sustainable dividend. An industrial company that grows its dividend and sees its payout ratio rise from 35% to 80% however does not strike me as an investment with a sustainable distribution. In another example, a company like Altria (MO) with a stated target of 80% and a history of a high payout ratio and rising earnings per share is another exemption that I consider.
2) Earnings Per Share
In general, we want earnings per share which are stable and growing. While some fluctuations in earnings per share do occur as a result of the economic cycle, we want to see a steady climb upwards over time. Without growth in earnings per share, a company cannot afford to raise distributions to shareholders as there is a natural limit to future increases. This will be evident when the dividend payout ratio starts increasing, while earnings are stagnant.
Rising earnings provide the fuel behind future dividend increases. In general, a healthy company will grow earnings over time, distribute a portion to shareholders in the form of dividends, and reinvest the rest to maintain or grow the business. A business with stable earnings can provide more reliable dividend payments than a business with more volatile earnings streams however. For example, most automotive companies in the world are cyclical companies. This means that their earnings ebb and flow with the ebb and flow of the economy. As a result, earnings go from highs to lows rather violently. When times are great, earnings are at their peak just as the economy is at its peak. The dividend payout ratio looks high, but this is usually a mirage, because earnings are about to take a dive just at the economy is taking a dive. This rapid fluctuation in earnings is the reason why there are no auto companies which are members of the dividend achievers index.
3) Business model
The stability of the business cannot be emphasized enough. Companies with strong earnings and revenue streams, which are less sensitive to the economic cycles can afford to pay dividends come rain or shine. When reviewing the longest streaks of dividend increases, I have found quite a few utilities and consumer staples companies. When the demand for the products or services is relatively inelastic, you can afford to maintain and grow dividends, since you have better visibility about the near term business prospects. That doesn’t mean to focus only on a few industries however, since things can change over time. This is why we need to be diversified, but also not to diversify for the sake of diversification either.
4) Debt and acquisitions
I rarely discuss debt in my analysis. In my experience, I have found that debt in the normal course of business is not a major issue when it comes to dividend safety. Debt can become an issue when it is coupled with a major acquisition. When you take on debt, you are essentially spending money today that you do not have, and as a result the future you has to pay for a period of time. Leverage is a two-way street that enhances your performance on the upside or the downside. If you acquire a business with all debt, and the business performs well, it can pay for itself from those profits. This leaves you with the debt paid off, and the business being your own letting you get future dividends in perpetuity. If you the business fails however, you have to still pay that debt and interest on it, which will hurt performance. If you are too leveraged, it may mean increased risk of bankruptcy if you have less wiggle room if business turns soft.
When you acquire a company, there are a lot of good things that can occur – namely synergies, increase in scale of operations, adding new products and expanding the business reach. However, a lot of things can happen that can derail acquisitions including having different cultures, integrating different systems and actually realizing those efficiencies of scale.
In my experience, there have been several companies that cut dividends after large acquisitions that were paid for with debt. Those include Pfizer (PFE) and Cedar Fair (FUN). If we talk purely about debt, we have Kinder Morgan (KMI) which had to cut dividends in 2015 after its credit rating took a hit after an acquisition.
In general, I do not look at debt too much. Again, as stated above debt can be an issue when combined with a major acquisition. This usually leads to a halt to future dividend increases, and sometimes even to dividend cuts. Many investors look at debt to equity or debt to assets. I prefer looking at interest coverage from earnings.
So if a company earns $100 million in profits, and spends $20 million on interest expense, I would argue that debt shouldn't be an issue.
5) Things Change
Unfortunately, sometimes things happen. When you buy a security with bright prospects, great valuation and attractive payout ratio today, you may not be aware that changes may be coming years or decades down the road. Technologies disrupts businesses, but also consumer tastes change as well. The economic cycle can be ravaging for businesses, and poor management may also be to blame. This is why we need to diversify as investors, in order to mitigate the effect of disasters on our retirement projections.
For example, investors who bought GE for the dividend growth were negatively impacted by the dividend cut in 2009. This was the first dividend cut since 1938. If you bought GE in 1995, you may not have expected that 4 years later this company would cut dividends because of its financial division. Nor would you have expected that the company would cut dividends in 2017 and eliminate them in 2018. The writing was on the wall when the dividend payout ratio increased beyond 60%, which indicated that the dividend would be cut. However, that was many years after our hypothetical investor bought GE in the 1990s. Now GE has cut dividends in 2017 and 2018.
In another example, when I bought Coca-Cola (KO) stock in 2008 and 2009, I saw the company as a solid dividend payer that will grow earnings per share and dividends per share for years down the road. Unfortunately, the company has been unable to grow earnings per share since 2012. Coca-Cola has continued raising its dividend however. As a result, its dividend payout ratio is very high, which means that the dividend is less safe. If Coca-Cola manages to grow earnings from here, it will likely be able to grow the dividend and would reduce the dividend payout ratio. The lower payout ratio will result in a higher margin of safety of the distribution, making it more resilient to external shocks.
In order to prevent damage from changes, I have several controls in place. I try to be diversified and own companies representative from as many sectors and industries as possible.
Another investment where things have not turned out as expected is IBM (IBM). The company expected to hit $20/share in earnings per share by 2015, and was buying back stock for years. Once it failed to reach its goals, IBM has continued raising dividends and buying back stock, but earnings per share have been going nowhere. After the recent acquisition of Red Hat, the company has announced a halt to its buybacks. This is ironic, because shares are selling at a multi-year low. While the dividend may be safe for now, the magic cocktail of new acquisitions, flat earnings per share, increased debt levels and high payout ratios and multi-decade high in the dividend yield make the distribution less safe.
However, I also focus on my entry criteria when adding new funds to work or allocating dividends for reinvestment. In addition, I sell after a dividend cut, and reinvest the proceeds elsewhere to minimize the blow to dividend income.
Today we discussed five factors I leverage to reduce the risk of dividend cuts. While the risk of dividend cut will always be out there, I believe that it can be managed by the strategic dividend growth investor. The nice factor to consider is that in a diversified portfolio consisting of 50 securities, one dividend cut by 50% is easy to overcome if the rest of components grow distributions to offset the cut. In addition, by selling after a dividend cut and reinvesting the proceeds in a company that keeps growing distributions can have a positive income and psychological benefit for the investor, because it would allow them to reasses the situation with a cool head.
Having an investment plan that focuses on dividend safety, valuation, and sound portfolio management could ultimately be beneficial in including all factors listed above, and help the investor reach their goals and objectives.
Full disclosure: Long KO & MO.