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 flow ((That is, cash flow left over after the company reinvests in the business.)). 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 cover ((Free cash flow/dividend.)) 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. ((See Barriers To Change: The Real Reason Behind The Kodak Downfall on Forbes.))

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.

Believe it or not, Monevator is a blog about securing financial freedom.

Originally it was focused on retiring early, but during a sabbatical I discovered I missed doing good work for money, provided it was on my own terms.

Nowadays I think I’ll always do something, even into my old age – and even if I don’t really need the money.

I enjoy half of what I do a lot, and I’d enjoy it even more if it was optional. I also suspect there are social and health benefits to staying engaged with the economy – provided you like what you’re doing.

(Hate your job? Quit today).

But you might want out of the game altogether. I hope our articles can help you either way.

I’m perfectly agnostic about how you plan to use your financial freedom.

I imagine most readers want more time back, or an income stream to support other ambitions. Or maybe you do want to retire very early, or perhaps you want to downsize with security, or travel, or write novels, or breed rare goats.

Do you want to make a million? You can stick around, too.

Perhaps you want the financial freedom to sell ice-creams on a beach in Bali on the minimum wage while living the higher-rolling lifestyle back at home, funded out of your savings and investments.

Material goals aren’t my cup of tea, but each to his or her own.

Looking to the end game

I began with ‘believe it or not’ because Monevator’s ultimate motivation – securing financial freedom – gets lost day-to-day in the minutia of our posts about everything from passive investing and global trackers to retirement income and investor psychology.

Some blogs are good at keeping their message up-front, which is handy for newcomers. Maybe I need to try harder, but there’s so much else to talk about – especially for UK investors and spare room entrepreneurs. We don’t have as many options to choose from as our US brethren.

Yet the danger is Monevator looks like a site about making money for it’s own sake. And that’s a danger that can affect your own investing, too.

Here’s a fairy tale to explain what I mean.

A very pessimistic person – the type you find writing comments in CAPITALS on Web forums – decides to prepare for the breakdown of civilisation.

He sells his portfolio, his house, his car, and even his iPad, which he rightly suspects won’t be much use when he’s hiding in a cave from cannibals.

Just before money becomes entirely useless, however, he spends his last savings on the usual post-society breakdown survival kit:

• Gold coins
• A shotgun
• 5,000 cans of beans

A few months on, and society does collapse – just as our doomster predicted.

You might think he’s sitting pretty. And he would be, except for one vital oversight.

He forgot to buy a can opener!

Financial freedom and you

I hope you think of me in the endless dark nights after the fall of the West. Toast me as you tuck into your beans. Hold aloft your remembered can open.

Of course this isn’t really a post about surviving in a post-apocalyptic world of tinned food and bad breath.

Rather, it’s a reminder that you need to think about your own financial can opener.

If you don’t know what it is, then you could end up surrounded by pots of money and no clue how to use it – or even how you got there.

• What are you investing for?

• What is your plan to achieve financial freedom?

• How will you know when you’ve achieved your goals?

• What have you forgotten?

Remember Curt, the tin can millionaire who made a fortune scrounging for pennies but who lived like a tramp?

Perhaps he had found his can opener. Maybe the freedom of knowing he had money enabled him to live free of material concerns.

Lots of people condemned him. But was he so different from a Zen master who forsakes worldly cares, or the flower children of the 1960s? History salutes them as visionaries.

Then again, maybe Curt didn’t know what he wanted the money for.

Maybe he wasted his life collecting tin cans when he would have been happier island hopping in the Philippines, or teaching French in Africa, or painting in the Swiss Alps, instead of just stashing his cash in a vault beneath them.

I think that’s why people reacted so negatively to Curt’s story. He could have done anything, but it seems he chose to do nothing.

The world is full of opportunity, and pitfalls too. Don’t hoard assets for a future that may never come, or that you don’t want anyway. Don’t let anyone tell you the reason you’re seeking financial freedom isn’t the ‘right’ one.

Know where you’re going. And don’t forget your can opener.

What caught my eye this week.

Here’s a sign that we’re neck deep in a bull market in global equities – shares are by far the riskiest mainstream asset class, but we hear much more concern, comments, and confusion about bonds.

In the absence of high inflation, the government bond portion of your portfolio is very unlikely to blow up. And even if we did see high inflation, it’d be a slow-motion car crash sort of disaster, as opposed to the hurricane of a true equity market crash.

Yet people fret about the bogeyman of a bond market rout, with some even saying they feel safer with 100% in shares. (I’d say cash is a far better replacement right now, if you must play swapsies).

Bond phobia is clearly a global affair, because other sites are wading in on bonds more, too. Here are a couple of good articles from just the past week:

• Why your bond ETF is not losing money [Canadian perspective, so don’t worry about the specifics. It’s an excellent general primer.] – Canadian Couch Potato

• Rates change, but the role of bonds doesn’t [This one is US, so just ignore the bit about IRAs] – Vanguard blog

We’ve also written a lot of articles about low-risk government bonds in the past. Enjoy!

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