I recently spent some time teaching corporate finance to MBA students at a local university. I found it an invaluable experience (my students may disagree!) as it required me to review the finance basics I learned years ago and then figure out ways to teach them to others.
During our class discussion on equities, we compared and contrasted dividends with bond interest.
One advantage of dividends versus bond interest is that dividends can increase over time, providing an inflation hedge to your income stream.
As the legendary fund manager, Peter Lynch put it in his book Beating the Street:
Whereas companies routinely reward their shareholders with higher dividends, no company in the history of finance, going back as far as the Medicis, has rewarded its bondholders by raising the interest rate on a bond…
The most a bondholder can expect is to get his or her principal back, after its value has been shrunk by inflation.
On the other hand, dividends, unlike interest, are not a contractual obligation and investors have no recourse if a dividend is cut.
The company’s board of directors and executives periodically decide on how much of a payout the business can sustain. If the company needs cash or is concerned it can’t afford the payout, a dividend cut can occur.
Out of the blue
To illustrate, I bought shares of Pfizer in July 2008 when it had a dividend yield of 6.9%.
Sure, I conceded, there were concerns about patent cliffs, but it had increased its payout for 40 consecutive years, had recently boosted its payout by 10%, and had an AAA credit rating. As far as dividend pedigree goes, Pfizer was near the top of the charts. It seemed like a classic value play.
In January 2009, however, Pfizer halved its dividend to help finance its mega-acquisition of rival Wyeth. In one foul swoop, Pfizer’s board erased four decades of its stellar dividend track record and was no longer a so-called dividend aristocrat.
Thankfully, the amount lost was manageable, and the experience served as a lesson that no matter the track record, balance sheet, or even management’s reassurances, no dividend is guaranteed. Each company has a breaking point.
Past and future
It’s easy to forget the pain of dividend cuts when the markets are sanguine. The cuts we endured during the financial crisis have since drifted further in the rear view mirror. But eventually we’ll run into them again.
What will bring about the next round of mass dividend cuts is impossible to predict, but the rapid pace of innovation and competitive disruption is a trend that I believe will not go away anytime soon:
- Traditionally ‘safe’ low beta consumer staples firms are facing volume pressure as consumers increase online spending.
- Private label brands have become more comparable in product quality and undercut branded names on price.
- Integrated energy companies will need to reckon with dramatically lower costs for renewable energy and innovations in electric vehicles.
It’s difficult to conclude that any broad industry is as defensive as it once was. And, by extension, there are probably no industries where cash flows and therefore dividends are automatically well-protected today.
So, what can you do as an individual investor to reduce the risk of a shocking dividend cut?
Here are three strategies to consider.
Mind the pace of industry change: Imagine trying to become a chess master if the rules changed every year. Instead of an 8×8 board, now it’s a 16×16 board. Now the king can move like a queen. And so on. It would be very difficult to build skill in such a setting.
Similarly, CEOs and CFOs in rapidly-changing industries can struggle to create enduring value when the competitive landscape is always morphing. Such companies must invest increasing amounts in capital expenditures and research and development just to keep pace. Few executives are suited for this challenge, and the growth furnace is fed with cash flow that would otherwise have been earmarked for dividends.
Instead, dividend investors are best served researching companies in industries with low asset growth, tiny shifts in market share, and where technological innovations are either a small issue or, better yet, can be used to the industry’s advantage via productivity growth.
Keep an eye on free cash flow: Over time, dividends must be funded by free cash flow1. Sure, companies can temporarily finance dividends with debt or asset sales, but eventually the bill comes due.
If you notice a company’s free cash flow cover2 trending below 1.5 times, it is time to ask some questions. Is the company running out of growth opportunities? Is the diminished cover due to revenue or margin pressure? If so, what’s causing it to occur?
Slowing dividend growth can be another sign that the board is concerned about future cash flow generation. When Tesco slammed the brakes on its dividend growth in 2012, it was a red flag that the board confidence was shaky.
Get some culture: Eastman Kodak is the poster child of fallen blue chip dividend payers. Many people point to the rise of digital photography as Kodak’s downfall, but, in fact, Kodak recognized the trend toward digital in plenty of time.
Kodak’s issue – and what likely sealed its fate – was a culture of complacency that prevented the company from being in the vanguard of the digital photography revolution.3
Are the companies you own culturally able to adapt to new challenges? It’s not an easy answer, particularly if you don’t work at the firm, but it’s one worth investigating.
These days, this is possible with sites like Glassdoor, where you can read employee reviews of the company. Local business newspapers can also be a valuable resource. If a company is a great place to work or is doing something unique, there are good odds that a local business journalist has covered the story.
You can also see if there are YouTube interviews with company leaders. What is their demeanor?
Finally, see how management reacted to changes in the past. Were they defensive on the conference call following a bad quarter or did they admit a mistake and outline plans for fixing it?
Whenever I speak with a company executive, culture is the first topic that I bring up. You’d be amazed how few companies have a good and enthusiastic response to this question. As such, pulling the thread on culture is worth your research time.
If the company can’t adapt to industry changes, the long-term viability of the dividend should be a concern.
Keep your eyes open for dividend cuts
A dividend investor’s job is to be ever vigilant. Even companies with distinguished track records and healthy balance sheets can take a turn for the worse in an increasingly competitive marketplace.
The earlier we identify trouble spots in our research, the more likely we’ll be able to preserve our capital and income.
Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.
- That is, cash flow left over after the company reinvests in the business.
- Free cash flow/dividend.
- See Barriers To Change: The Real Reason Behind The Kodak Downfall on Forbes.