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 fell 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.
Tall order
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.
I don’t mean to be rude, but can someone explain to me why I should care about dividends rather than total return? Why do articles like this one place a special emphasis on companies that pay out regular high dividends? Money is money, right?
There’s a tax difference, but it seems to be in favour of capital gains so I don’t think that that’s the reason.
@Oscar — You’re not being at all rude, it’s a very valid question, but you’ll appreciate we get asked this every time we run any article on dividends and so from my side in aggregate it’s a little tiresome.
It’s a personal preference some active investors have. I’m not really one of them with my own (active) investing at the moment, though I do still think many investors would do better focusing on income for various reasons.
Anyway, you’ll find some more thoughts here: http://monevator.com/whats-wrong-with-dividends/
I’m likely to delete further existential questions not specifically relevant to the article, just to keep things on-topic, as per my comments a couple of months ago here.
“Keep your eyes open for dividend cuts” – nice idea, but the reality is that by the time you spot them coming, everyone else has as well, and the price is lower. Better not to worry about it too much, diversify to reduce the impact of individual cuts, and work on your golf game while the dividends roll in. Who wants to spend their time ‘monitoring’ all their holdings. Not me.
Nice up-to-date shortcut mentioning glassdoor.com, when I first came across it ~10 years ago even the concept was incredibly new, exciting and revolutionary, but did it work?
At the time I worked for a nasty corporation with a toxic culture which was the opposite of what they claimed; all the worst corporate practice was dyed in the wool. A look at glassdoor comments from another branch by people I didn’t know who worked for the same company told me exactly what I was experiencing when I opened my office door.
So I totally agree that knowing the company culture is as good a predictor of the future as you can get on this planet. I personally knew a midlevel manager at Kodak (my neighbour in the mid-2000s) and he told me top management simply had no ideas on how to turn it around, so that rings true; he got depressed with endlessly firing people.
As Charlie Munger said, show me the incentivisation system in a company and I’ll predict what will happen; so surely that is just excellent but common sense?
Kodak was a poorly managed firm for decades. I once worked for one of their major customers and saw them try and fail at marketing both batteries and videotape. The videotape idea was potentially a winner as the technology was very similar to film manufacture; applying precision coatings to a substrate. In both instances they produced quality products, but priced themselves out of the markets, mistakenly thinking people would pay a “Kodak Premium.”
You are correct that they were early players in the digital photography space, but they failed to leverage their early breakthroughs. Even had they succeeded, smart phones later basically killed off the consumer camera market. At best Kodak would have been left supplying imaging chips to Apple and Samung, which is not a very high-margin business.
Hi, I was very interested to see your discussion around dividends vs coupons. I have some concerns about Contingent Convertible (CoCo) bonds. These pay coupons initially prior to any conversion into equity, but the coupons can be cancelled without triggering either a default or conversion. These instruments are therefore, in my view, more equity like in their risk profile than bond like. However, when it looked like Deutsche Bank may suspend the coupon last year the whole CoCo bond market sold off by 30 points – implying that the investor base as a whole wasn’t aware of this feature. The largest buyer of these products seems to be Pension Funds which obviously makes it a problem for all of us.
A few years ago ,once I learned enough from resources like monevator about managing my own finances, I took the step to cut the umbilical to my old IFA. The principles I have applied since then have been to diversify investments globally using passive index tracking products, minimise costs and trading activities, keep calm in crises, and have a proportion in funds in cash and low risk assest like gilts to buffer something like 3 to 5 years of severe downturn in equity valuations.
However, now I’m nearing the point of needing to use the portfolio in retirement and I’m becoming confused about how best to go about this. I’d planned on selling assets each year for my additional income needs, but the alternative presented in this series of articles and others here (like greybeard’s investment trust series) suggest instead to rely on a small number of investments in individual company shares (or investment trusts) and monitor details of their performance on an ongoing basis. This appeals to my urge to tinker and scheme with this stuff, as if the little red devil on Homer Simpson’s shoulder came whispering in my ear too, but it seems to fly directly against the foundational principles of diversification and not fiddling with stuff all the time.
Selecting a small number high yielding stocks that produce a steady income year on year is appealing, but I am suspicious that this appeal is to psychological traits that lead to bad investment decisions, like a belief in gaining more while accepting less risk.
And more broadly there seems to me to be a big philosophical gulf (that I can’t articulate) between a strategy that maximises global diversification on the basis that one must necessarily be agnostic about the future performance of equities, and one in which it is a good idea to pin your future welfare on 15-20 equities mainly in the FTSE 100, on the basis of prognostications as to their financial outlook.
Futher enlightenment on this contrast would be welcome, by me at least.