Dividends are taking on new importance as the social aversion towards share buybacks has increased and investors make judgements about equity valuations in today’s environment. Recently, there have been several dividend reductions or suspensions as economic conditions have become more uncertain due to the COVID-19 pandemic. Some experts are projecting a 20-30% cut in dividends in 2020, which brings up the question if investing in dividend-paying stocks makes sense in this environment and how one can protect a dividend focused portfolio.
Dividend Actions by S&P 500 Member During the COVID-19 Crisis
Dividends have long been a popular way to return earned profits to shareholders and have been powerful indicators of management’s confidence in the business as dividend levels are expected to be sustainable through a full business cycle. The Dutch East India Company was the first recorded public company to ever pay regular dividends, which amounted to roughly 18% of the share value for almost 200 years from 1602-1800.
These challenging economic times have put tremendous pressure on companies’ cash flow, which in turn forces companies to make tough decisions when evaluating how to preserve their financial liquidity. If the Financial Crisis of 2008 was a guide, it is feasible that we will see a decline in the S&P 500’s aggregate dividend for 2020 based upon today’s crisis. During the financial crisis in 2008-2009, the S&P 500 saw 62 companies cut or suspend their dividend in 2008 with an additional 78 following suit in 2009. However, 151 companies, or 30% of the index, increased their dividend in 2009 as the economy was climbing out of recession. There are other levers that management can utilize while cash flows are under pressure before a dividend cut is implemented, with a cut typically perceived as a last resort. Alongside the suspension of earnings guidance this year, we have seen a significant number of announcements around reductions in share buybacks, lower capital expenditures and operating expense rationalization programs to preserve financial flexibility. A majority of these occur before consideration of cutting the dividend.
A popular metric referring to dividend coverage is the payout ratio, which is simply the percentage of dividends per share divided by the earnings per share. A payout ratio greater than 100 means a company is paying more out in dividends than it is earning. While this is commonly used, it may be misleading to rely solely on the payout ratio as a measure of dividend health and sustainability. Earnings per share alone do not portray a company’s whole profile as they can be influenced by non- cash items and therefore may not reflect the true cash flow dynamics of a company. Although we study the payout ratio, we find that dividends as a percentage of free cash flow is a more valuable metric.
When investing for dividend income, an investor must be careful not to simply seek the highest yielding companies for yield alone. Often, they are paying out too much of their earnings and the payout is either not sustainable or the stock is depressed for good reason. Instead, our focus is on selecting companies that have a history of growing profits and cash flow steadily that can support a consistent and growing dividend. In addition, we seek healthy balance sheets with reasonable leverage and an effective history of capital allocation. During these economically challenging times, these traits will result in companies that are more resilient and have the capacity and liquidity to maintain or increase their dividend. In addition, they are characteristics that can potentially contribute to outperformance with lower volatility over the long-term.
In reviewing your portfolio for resiliency, you can stress test your holdings using various forecasts to cash flow to give you an indication of where risks of a dividend cut are highest. Using models that stress test different sales and free cash flow margin levels can be a valuable technique when looking for dividends at risk of being cut. In addition, looking back to the previous recessionary times as a gauge of how particular companies fared and management reacted then can be insightful.
The anticipation of a dividend cut can often be identified based upon a stock’s performance relative to its sector, even in advance of an eventual announcement. Underperforming companies with outsized dividend yields suffer from an increasing cash flow drain to support their high dividend level. In addition, combining a large dividend with excessive buybacks or leverage can overwhelm the free cash flow generation at the expense of reinvesting in the business for future growth. That’s when tough decisions must be made because an unsustainably high dividend is not in shareholder’s long-term best interest if it creates an inability to grow, particularly when leverage is used to pay the dividend. Furthermore, when assessing safety of dividends, it can be dangerous to assume that higher-yielding stocks are going to be safe if they are paid by a large, well-established company that has been paying it for decades. Size alone or prior dividends do not ensure a perpetual dividend. Things can change, even for big companies.
In this historically low interest rate environment, dividend growth stocks continue to make sense if you are selective in the process. It is essential to evaluate several dynamics including the company’s fundamentals, history of earnings growth and margin profile, the stability of their cash flow and earnings streams, the strength of their balance sheet as well as their capital allocation strategy. These stocks can be an effective core part of your portfolio, allowing you to increase your income stream and provide opportunities for capital appreciation with a high-quality tilt.