Make sure you consider our 5 factors when choosing your next dividend-stock
Many private investors favour dividend-paying stocks as their primary investment, hoping to take advantage of healthy, consistent, and hopefully growing payments.
Dividends are one of the few places an investor can still get a reasonable yield in the current ultra-low interest rate climate. It can be incredibly rewarding, but it comes with additional risks. Serious investors need to analyse and understand the companies in question to get completely comfortable before investing.
Everybody has their own approach to picking out great "divi" stocks, but there are some factors that can be overlooked, and if you're not careful they could come back to haunt you.
In the following post, we'll discuss 6 key factors that you should consider as a dividend investor before placing that trade.
Competitive Edge
Investors buy solid dividend stocks to earn income over the longer term or to reinvest and reap the rewards of compound interest. For both of these strategies, sustainability and reliability of dividend payout is key.
For a company to offer a consistent dividend, it needs to keep its edge, or what Warren Buffett calls: Economic Moat.
Ask yourself, does this stock have a sustainable competitive advantage? If so, how long can it stay competitive? It needs to be able to protect its long-term profits and market share from competing firms and not be at risk from new disruptive forces.
As a dividend investor, you need to consider the nature of the market the company operates in, is it possible for newcomers to disrupt its performance with a different approach or technological advancement?
Even if it is able to protect itself, how serious is the competition? A company that’s concerned with the competition is less likely, or able, to raise its dividend consistently than a business whose position of strength is assured.
Example: Blockbuster
Four years after Blockbuster batted away the chance to buy a little known rival Netflix, the video rental behemoth had 60,000 employees, 9,000 stores worldwide, a market cap of $5bn, and revenues of $5.9bn. Its brand and footprint on the high street appeared to be its economic moat.
Just a year later, the company cut its dividend for the first time since 99', fast forward 6 years and the giant had been reduced to a shadow of its former self, bankrupt and delisted from the the NYSE.
What happened?
Its economic moat had been eroded as management made bad decisions in the face of disruptive competition. Shareholders of Blockbuster saw an eyewatering reduction in the company's value, from $5bn to $320m (once liquidated).
Dividend Coverage
Solid coverage is key to a sustainable dividend. Investors need to see decent cover in the stocks they choose to make sure there's a reasonable margin of safety for the company to sustain its payouts year after year, with the ups and downs of the economy. If a company can't sustain its earnings, long-term dividends could be at risk.
Most websites and financial news sources will quote dividend coverage using earnings per share to calculate the payout ratio:
Dividends per share / earnings per share
This is fine and will give investors a pretty reliable idea of whether the dividend is sustainable. Adopting this approach, we believe a minimum of 1.5x cover is required. A more stringent metric for calculating dividend cover is versus free cash flow (FCF):
Dividends per share / FCF per share
FCF = Cash from operations - Capital Expenditure
Free cash flow is in some respects a better method for gauging coverage as dividends are paid for with cash, not earnings.
As a result of accrual-based accounting, a company's cash and earnings profiles can deviate significantly depending on its type of business. Revenues can be booked long before the cash arrives. This can make dividend cover look healthier on an earnings basis than a cash basis. On the flip side, if a company is in the midst of a short-term CapEx program you would expect low or negative FCF for a time. It is critical to look back at a number of reporting periods to get a sense of dividend cover over time.
Example: AT&T
In AT&Ts Q3 interims in 2000, the company announced a quartely dividend of $.22 per share from $.35 a share in earnings, paying out just over 60% of its earnings (in-line with what a lot of investors consider to be an acceptable payout ratio).
In November 2000, AT&T cut its dividend after soaring debt and imminent maturity had forced management's hand to act. The cut essentially left investors with a 1% yield instead of 5%.
If investors had based dividend cover on AT&T's cash flow, they would have seen the cut coming a long way off. Between 99' and 00' the company's debt rose 40% and in 2000 free cash flow was more than $2bn in the red. Go back a few years and the cash flow problems are very obvious.
Great Balance Sheet
As well as solid coverage, companies need to have a solid Balance Sheet to be a sustainable and reliable dividend payer. If the company is financially secure, it can afford to pay out the dividend to investors without putting a strain on finances or its equity financing.
Companies with solid balance sheets can borrow money at better rates when they need to invest or pay for acquisitions, so they won't need to take any money from the dividend pool to finance these operations.
- How does net debt compare to EBITDA? There are sectors that are exceptions to this but normally anything less than 3x EBITDA is ok, less than 1.5x is healthy.
- What proportion of total assets are funded by debt? ie what is the leverage ratio? Again, different sectors have different acceptable levels but for most, between 30% and 60% is reasonable, above 60% and risk levels increase.
Dividend Policy
Before putting in an order for your dividend stock, make sure you've gone through the company's Annual Reports and checked Management's stated policy towards dividends. They should be easily found on the company website and will give you an idea of the board's motivations and strategy.
What is its stated dividend policy? Do Management have a progressive dividend policy, ie growing it steadily over time, or is the dividend a percentage of FCF each year, in which case it will be much more volatile? Is management happy to pay dividends consistently or do they prefer to pursue a share buyback strategy to return value to shareholders?
If the company does follow a progressive dividend policy, how many years has it managed to grow dividends?
Macroeconomic
Aside from the company-specific factors, it is crucial to consider the investment in the context of the broader economy. A serious investor would assess any individual dividend paying stock through the prism of his/her top-down view of the sector the company operates in, and the broader macroeconomic climate.
Examples of questions we ask ourselves:
- If oil prices half, what impact will that have on the ability for companies to maintain and grow their dividend?
- If shoppers continue to move online, how will this affect high street retailers and their cash generation over the next decade?
- If vaping continues to grow in the West and grows in popularity across Asia, Eastern Europe and the Middle East, how much will the global cigarette market decrease?
In conclusion...
The above factors are not an exhaustive list of things to consider when choosing dividend investments but it is how we think about it. You could spend far too much time drilling into the minutiae but if you've thought about the above then you should be most of the way there towards deciding whether a company presents a good long-term yield opportunity, or whether it is a value-trap to be given a wide berth. Happy hunting!
