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When a dividend investment goes wrong

Keeping Your Dividend Edge: A book by Todd Wenning

The following guest post is by Todd Wenning, author of Keeping Your Dividend Edge. Todd’s writing has often featured in our Weekend Reading links, and his excellent new book continues where his blog left off. For this article, Todd candidly admits what he got wrong with his investment in Tesco and considers the lessons we can learn.

Britain’s largest grocery chain, Tesco, was long considered a core holding of UK-based dividend investors. It was once one of mine, as well.

In its 2011 financial year for example, Tesco increased its dividend by 10.8% – marking an impressive 27 consecutive years of dividend increases.1

At the time, respected long-term investors like Neil Woodford and Warren Buffett held considerable positions in Tesco, suggesting the company passed their well-regarded filters.

In addition, Tesco’s UK market share was over 30% and its domestic dominance appeared safe.

More reasons to invest in Tesco

A further prong to my initial thesis on Tesco was that the company’s mistimed expansion in the US (known as Fresh & Easy) would eventually stabilize and rebound as the North American economy recovered – particularly in the Western US states where the stores were located.

I also thought Tesco’s investments in China would fuel earnings and dividend growth for years to come.

Finally, I believed the UK market would continue to produce plenty of cash flow to support international growth.

But the wheels began to fall off one at a time.

Tesco starts to tumble

My US turnaround thesis soon fell flat. In April 2013, Tesco announced it was exiting the US market and Fresh & Easy filed for bankruptcy protection. All of this resulted in over a billion dollars in trading losses and impairments.2

That in itself should have been a sign to sell. I rationalized, however, that with the Fresh & Easy chapter finally shut, Tesco could better focus on its other global operations.

Strike one.

Tesco also never figured out how to turn a steady profit in China. Ultimately, it entered into a joint venture with a large Chinese retailer who actually knew how to run a retail business in China. So much for the region fueling dividend growth!

Strike two.

With Tesco’s focus on its struggling international operations, it began losing ground to competitors in its home market. Indeed, a space race and pricing war simultaneously erupted between Tesco and other UK grocers like Sainsbury’s and Morrisons. Meanwhile discounters and higher-end specialized grocers alike feasted on the opposite ends of the pricing spectrum.

Even though Tesco seemed best-suited to survive this war of attrition, profit margins suffered. This put further strain on both free cash flow and earnings-based dividend cover.

In response, Tesco held its dividend flat starting with the interim dividend paid in December 2012. Then, in February 2014, it abandoned its long-held profit margin target in an effort to better defend its market position.3

Strike three.

Cut to the chase

While some warning signs were present – including that aforementioned long-time owner Neil Woodford bailing on Tesco in early 2012, and laying out a solid rationale for his exit – the combination of Tesco’s distinguished dividend track record, its vast real estate holdings, and its leading share of the UK grocery market seemed to me compelling reasons to hold and hope for a dividend turnaround.

Yet the numbers didn’t lie.

Tesco’s dividend health slowly worsened while its dividend yield steadily increased to more than twice the UK market average – usually a sign that something has gone wrong.

Prelude to the dividend cut: Tesco’s annual results

2014 2013 2012 2011 2010
Free cash flow coverage 0.59 0.18 0.59 0.66 1.78
Earnings coverage 1.61 1.17 2.51 2.57 2.41
Dividend per share 14.76p 14.76p  14.76p  14.46p  13.05p
Interest coverage 5.89 4.92 6.65  6.10  4.77

Financial years ending February. Source: Company filings, Morningstar.com

It was only a matter of time before Tesco’s board needed to make some tough decisions, and in August 2014, Tesco announced it would cut its interim dividend by 75%.

A month later, it disclosed it had overstated its profit forecast for the year.4 In January 2015, Tesco canceled its dividend for the following fiscal year. 5

Lessons learned

This was truly a brutal end to what initially appeared to be a high-quality dividend investment. But in the spirit of learning from our mistakes, what lessons can we takeaway?

Management changes matter

When a very successful CEO retires or leaves a company for non-obvious reasons (e.g. he or she isn’t 65 or older and looking to retire, say), it’s time to reassess your investment thesis.

In June 2010, well-regarded Tesco CEO Terry Leahy, who during his 14-year tenure more than quadrupled Tesco’s sales and pre-tax profits, took many by surprise6 by announcing his retirement as of March 2011 at the still-young age of 55 and while the company still had a number of unfinished projects overseas.7

With the benefit of hindsight, this was an early red flag that changes were afoot and that all may not be well. Though a major management change in itself may not be a good reason to sell your position, an important change like this during a critical time should prompt you to monitor the company closely in the coming quarters for any signs of trouble.

Pay attention to dividend growth trends

The fact that Tesco slammed the brakes on its dividend growth rate after years of solid increases was a sign that management and the board were growing concerned about the underlying business.

Highly cyclical companies like materials, energy, and semiconductor companies may prudently hold their payouts flat for a year or two during a down cycle, but this generally shouldn’t happen at companies in more defensive industries like food retailing, consumer goods, or utilities.

When it does, something’s up.

Free cash flow can tell a different story to earnings cover

As the above table shows, Tesco’s dividend looked well covered by earnings, but it wasn’t covered by free cash flow. Instead, Tesco supported its dividend through real estate monetization (i.e. sale and leaseback arrangements and the like) and not by free cash flow generated through operations.

Put simply, that’s not a sustainable strategy. It took me too long to recognize the problem with my own investment in Tesco.

Bottom line: if the company isn’t covering its dividend with free cash flow, you at need to ask tough questions about how the company plans to afford its payout going forward.

Watch out for big capital investment misses

When companies make large investments that ultimately fail, it can cause the board to reevaluate its dividend policy. Tesco’s board may have, for instance, increased the dividend in prior years under the assumption that the investments in North America and China would work out.

A big swing and miss may also require the board to reprioritize cash flows to pay down debt incurred to fund the investments.

Todd is an equity analyst based in the US. His opinions here and in the book are his own and not those of his employer. Keeping Your Dividend Edge is available from Amazon, at a bargain £1.99 on Kindle or £9.99 in paperback.

  1. Source: Tesco plc. 2011 Annual Report. http://www.tescoplc.com/files/pdf/reports/tesco_annual_report_2011.pdf []
  2. Source: Sonne, Paul and Evans, Peter. “The $1.6 Billion Grocery Flop: Tesco Poised to Quit U.S.” WSJ. December 6, 2012. http://www.wsj.com/articles/SB10001424127887324640104578160514192695162 []
  3. Source: Wood, Zoe. “Tesco Abandons Space Race and Invests Resources in New Price War.” The Guardian. February 25, 2014. http://www.theguardian.com/business/2014/feb/25/tesco-supermarket-price-cuts-profit-forecast []
  4. Source:Reed, Stanley. “Tesco Says It Overstated Profit Forecast.” NY Times. September 22, 2014. http://www.nytimes.com/2014/09/23/business/international/tesco-shares-slide-on-news-that-it-overstated-profit-guidance.html []
  5. Source: Tesco plc. “Trading Statement for 19 Weeks Ended 3 January 2015.” January 8, 2015. http://www.tescoplc.com/index.asp?pageid=188&newsid=1127 []
  6. Source: Sibun, Jonathan and Fletcher, Richard. “Surprise as Sir Terry Leahy Resigns from Tesco.” The Telegraph. June 8, 2010. http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/7812463/Surprise-as-Sir-Terry-Leahy-resigns-from-Tesco.html []
  7. Source: Tesco, Annual Review, 2011.https://www.tescoplc.com/files/pdf/reports/tesco_annual_review_2011.pdf []

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{ 23 comments… add one }
  • 1 gadgetmind May 20, 2016, 9:17 am

    I told my wife that she needed a retailer in her portfolio, explained why she couldn’t have Waitrose, and gave her the choice of Tesco or Sainburys. She chose the latter because “Tescos is a dump” and now thinks she’s an investment genius. In retrospect, maybe she is.

  • 2 green_as grass May 20, 2016, 10:49 am

    I like the idea of a dividend income portfolio very much But I am more attracted to the idea of a smallish basket of Investment Trusts covering different sectors rather than picking stocks myself. Monitoring companies for warning signs that their dividends are about to go tits up (as in the above post) is something I would probably be be very bad at, whereas checking the performance of an Investment Trust is just about within my capabilities.

  • 3 gadgetmind May 20, 2016, 11:08 am

    ITs can work well for income and the “B7” and “B8” portfolios discussed on Motley Fool are a good starting point.

  • 4 Naeclue May 20, 2016, 11:27 am

    27 consecutive years of dividend increases! If that is not huge evidence in support of a dividend income strategy then what is? What could go wrong?

    Lesson learned, or reinforced, for me is that if Todd Wenning got this wrong, what hope would I have when I know that I would not have the requisite skills and certainly not the patience to run a portfolio of individual shares?

  • 5 ABC123 May 20, 2016, 12:36 pm

    This just proves why “high yield portfolios” are a waste of hard earned money unless you know what you’re doing with individual companies and you have the time to follow each one properly. This year’s good dividend payers are next year’s basket cases (to a greater or lesser extent) – think RSA too!

  • 6 gadgetmind May 20, 2016, 1:45 pm

    I built up a high yield portfolio for my wife during 2011/12 as our ISAs were full, we had some spare cash, and there were lots of bargains to be had.

    Total buys (including some top ups) came to £63.5k, total sells (I’m now dismantling it and feeding it to our ISAs) are £46k, value of what we’ve got left is £42k and we’ve had £13k out as dividends. So £63.5k in, £101k out, assuming no big falls before everything can be sold.

    We bought at a flattering time, but even so have suffered with some big drops in mining and utilities. However, many holdings doubled or tripled in value, which more than made up for it. The key, as ever, is to diversify.

    Looks like I’ve easily beaten the FTSE 100 TR, but let’s put that down to luck, eh!

    And note that we do have pensions, ISAs, ITs, preference shares (yup, still got them!) and cash alongside, so we were not going mad with our life savings or anything.

  • 7 weenie May 20, 2016, 1:55 pm

    Interesting post but an unfortunate reminder of my naive decision to buy Tesco when I first dipped my toe into dividend investing in 2014….just as the share price started its plummet – ouch!

    I’ve still got them (and some others which probably should have been ditched/never purchased) and I hang on with grim hope that at some point, I’ll get some dividends again!

    As per green_as_grass, I’ve been buying more investment trusts of late, although I’ll probably still pick the odd individual stock if it takes my fancy.

  • 8 gadgetmind May 20, 2016, 2:14 pm

    If Buffett can get it so very wrong, I don’t think we can beat ourselves up too much. Information flow from management was on the deceptive side of diabolical, and their accounting somewhat “creative”, and as PIs we don’t have the resourced to dig any deeper, though warning signs were there.

    As long as you can stick to a rule like “no more than 5% in one share, no more than 10% in one sector” then you can still sleep at night.

  • 9 Jim McG May 20, 2016, 2:18 pm

    “If Buffet can get it so very wrong…..” Indeed. I read all these analysis of companies the same way I read the Racing Post. Gambling can be fun if you don’t take it too seriously and are prepared to take a bath every now and again. But I prefer Matched Betting.

  • 10 John from UK Value Investor May 20, 2016, 2:38 pm

    As a recovering Tesco investor I like this sort of bare-your-investment-soul article. Get it off your chest, admit your mistakes and move on. And, as has been said repeatedly, the three most important words in investing are diversify, diversify, diversify.

  • 11 Ric May 20, 2016, 2:47 pm

    Thanks for the case study Todd, such case studies are one of my favorite ways to learn.

    I was very lucky, having sold out on Tesco 2nd April 2014. Looking back on my notes it was due to negative FCF & negative EPS growth, as well as a fair number of poor or mediocre or poor scores in my screen, such as the Piotroski F-Score. I remember it was hard at the time as I had an emotional attachment, it having been one of my earliest & profitable stock selections. My sympathy to those less lucky, who took the ride down. I just happened to have the right filters in my screen to spot this one. On many other stocks I’ve been less fortunate.

  • 12 gadgetmind May 20, 2016, 2:54 pm

    OK, how about “If ToddW, Buffett, and JohnK from UKVI can get it so wrong …”

    John did a “Some lessons learned from the Tesco value trap” article on the 6th for anyone who didn’t spot it.

  • 13 grey gym sock May 20, 2016, 3:17 pm

    i still have my tesco shares … they’re about 50% down on from what i paid for them (ignoring dividends). i expect they’ll pay a dividend again eventually, though at a lower level than before.

    but it’s a small part of a diversified portfolio (in which many, though not all, shares were chosen because they paid decent dividends). so no real harm done.

    why do i still hold them? it’s very simple: my policy is to hold on to the losers, and hold on to the winners.

    of course, my investment case for tesco (vague though it was) has been blown apart by subsequent events. but is that a reason to sell? expectations are lower now, but so is the share price. the market may have over-reacted, and marked tesco’s share price down too far – that can happen. or perhaps it hasn’t in this case – i really don’t know.

    with hindsight, i should never have bought it. or i should have sold at the first sign of trouble. but good companies can have a spot of trouble and recover, and you can hurt your returns by selling out on what turns out to be a mere hiccup.

    i hold some shares, both winners and losers, which i bought almost 20 years ago. the more extreme losers (worse than tesco) have dwindled so far in value that it hardly matters what i do with them. i have sometimes sold losers – and indeed, winners – but i try to do it less and less. i should perhaps do an analysis of whether i’d have been better off if i’d never sold anything.

  • 14 gadgetmind May 20, 2016, 3:37 pm

    Perhaps the bigger question is whether you’re better off than if you’d never bought anything?

  • 15 cat793 May 20, 2016, 3:50 pm

    Isn’t it articles like this that reinforce the case for passive investing in low cost indexes?

    None of us can know or predict the future. We are kidding ourselves if we think we can. If Tesco can go bad then so can any other blue chip. Remember GEC or ICI etc etc? Owning a spread of businesses hopefully aiming to make a profit for shareholders is probably as good as it gets for us.

  • 16 The Investor May 20, 2016, 4:46 pm

    Isn’t it articles like this that reinforce the case for passive investing in low cost indexes?

    Hi @cat793! Articles like this are really aimed at those who invest directly in shares. 🙂 We are a broad church here on Monevator, even if it is a Church of Truth, and I’ve sadly allowed the number of non-index fund articles slide in recent years.

    But to that point, if the takeaway for you was that you (or indeed that most people in your view) should own low cost trackers, I’d be the last person to disagree.

    The main reason to invest actively is for the challenge and because you’re an investing nutjob like me so you love it. Most people will do better in index funds.

  • 17 magneto May 20, 2016, 5:25 pm

    Tesco was the penultimate individual stock sold by us.
    Sad to admit Tesco had been held for many many years, without due scrutiny to the underlying problems.
    So now we are free of all individual stocks with all that associated head scratching and dithering.
    The first Tesco dividend cut (can’t now remember when that was ) and we bailed out.

    The above gadgetmind reminder, was that the one linking to Terry Smith’s article in the FT?
    As I recall TS revealed he had bailed out/avoided Tesco due to declining ROCE, well ahead of any profit warnings and share price slump.

    For any determined individual share buyer, ROCE seems pretty fundamental. So why didn’t I pick it up!
    Sloppiness?

  • 18 gadgetmind May 20, 2016, 5:41 pm

    I was mentioning the UK Value Investor article where JohnK laments the demise of Tesco much as this articles author does.

    Regards trackers, yup, use a lot of them, but decided to go for a portfolio of shares partly for the challenge and partly to better understand myself as an investor.

    The main reason that it’s not for everyone is because you need at least 15 holdings, ideally 25 or so, and to keep charges down, you need £2k-£3k in each company. The “ideal” High Yield Portfolio as per Motely Fool “rules” is 25 shares at £3k each, so a £75k investment. I nearly did this but decided to slap some money into Personal Assets, Ruffer and RIT alongside this because 2011 was an uncomfortable time.

    I’ve gone massively more passive since then, and all our our SIPPs and ISAs use mostly Vanguard ETFs, and even my company pension is in a fund that uses active asset allocation on top of Blackrock Class C trackers.

    The unwrapped HYP was kind of fun, but tracking dividends and corporate actions was a pain as many of the latter are very non obvious, and I didn’t want capital gains issues. As the HYP is slowly sold down (matching winners with losers to avoid CGT) it’s feeding into ISAs and going passive.

    Phew!
    I have no idea what we’ll do when I extract our 25% pension lump sums. I want a mix of dividend and bond income, and it will all be unwrapped, so things will get interesting again.

  • 19 dearieme May 20, 2016, 8:00 pm

    “In June 2010, … Tesco CEO Terry Leah … took many by surprise by announcing his retirement as of March 2011 at the still-young age of 55 and while the company still had a number of unfinished projects overseas.”

    Get out before you’re found out, eh? My wife chided me for being cynical when I said that over breakfast. Maybe she was right: maybe he’d been found out and had been pushed out.

  • 20 gadgetmind May 20, 2016, 10:00 pm

    Lunch with the accountants, dinner with the lawyers, many breakfasts with family.

  • 21 Jon May 21, 2016, 10:02 am

    Retail, Technology and Banks are ones to ignore for the long term. They are easily disrupted.

    Although I have shares in mega banks like HSBC, WFC and tech company IBM.

  • 22 grey gym sock May 21, 2016, 10:11 am

    gadgetmind: “Perhaps the bigger question is whether you’re better off than if you’d never bought anything?”

    better off than if i hadn’t invested? yes, lots.

    better off than if i’d only used collective investments? not so clear. my individual picks (of UK shares) were overall marginally ahead of the FTSE all-share index when i last looked. but i should really have started buying ex-UK shares sooner (which i did eventually, via collective investments).

  • 23 gadgetmind May 21, 2016, 1:20 pm

    Well, the rather glib adage is that you should make your first million from collective investments!

    Regards technology, it’s been by far my biggest investing success, and where much of the money for other investments come from, but I am very actively diversifying.

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