[Investment] Avoiding The Dividend Income Traps

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Summary:  Key for dividend income investors is to find those companies that will deliver a sustainable and growing stream of dividends.

 

We suggest six principles that can help investors to minimise their risk of failure.

 

We group the principles in Quality and Valuation metrics and provide examples of our scoring system.

The baseball player, Yogi Berra, once famously remarked that people should decide where they want to go, or they may end up somewhere else. It is no different in the investment world. For investors that are interested in building a portfolio of companies that can deliver a growing income stream for years and decades to come, we suggest six principles described below.

The key objective is to select those companies that not only offer attractive starting yields but where there is also ample evidence that the dividend is sustainable and will grow faster than inflation, over time. Here are our six principles:

1. A track record of consistent and growing dividend payments: Does the company have a history of consistent and growing dividend payments ahead of inflation, over time? We look for a history of at least 5 years but preferably much longer. If the company has missed or lowered a payment in the past, we want to be sure to have a full understanding of that episode and of the relevance for future payments. This principle is backward looking, but it serves to establish whether the board of the company, who will ultimately decide whether to pay a dividend, has a commitment to paying regular dividends, even when times are tough.
2. A rock-solid balance sheet: Does the company carry high levels of debt on the balance sheet that can limit its ability to pay future dividends? This could be the result of limitations placed on the company by lenders or simply the result of a higher interest burden in a rising interest rate environment. Generally speaking, we would be looking for companies with a net debt to capital ratio of less than 60% and an EBITDA interest cover of more than 3.0 times. However, these are not absolute rules and depend on the cyclicality of the underlying business - companies with very stable income streams can afford to take on more debt, while more cyclical companies should carry lower debt levels. To determine cyclicality, we look at the stability of revenue, profit margins as well as the return on capital.
3. A pay-out ratio that leaves room for unforeseen events: The business and financial market environment moves fast, and the best designed business strategies can unravel quickly, leaving dividend payments at risk. It is preferable that companies leave considerable room for error and the ability to sustain their dividend payments when times get tough. The cyclicality of the company's revenue also plays a role, but we would be looking for pay-out ratios of less than 70% as a general rule. In this context, we also prefer, in most instances, to define the pay-out ratio as the total dividend paid as a portion of the free cash flow (that is operating cash flow minus maintenance capital expenditure).
4. Prospects to grow the dividend faster than the rate of inflation: A company that is unable to grow its dividend over time is unlikely to provide an attractive total rate of return (that is the dividend income plus capital appreciation). We spend a fair amount of time to understand the key business drivers, the competitive positioning of the company, cash generation, and future capital requirements for expansion and maintenance.
5. An attractive starting dividend yield: As we pointed out in the article "Is Dividend Investing Dead", stocks with "average" yields perform better over time than the low yield or high yield group. Our primary focus is therefore on this middle group which currently offers dividend yields (in the U.S. investment environment), of somewhere between 2.5% and 5.0% combined with growth of 5-15% per year.
6. A reasonable valuation: While the key focus for dividend investors should be the sustainability of the dividend, the stock valuation should also be assessed. It serves no purpose to receive a high dividend combined with high capital losses. We use discounted cash flow analysis and appropriate relative valuation measures for each company to compare the current valuation to its peers and against its own history.

We combine the first 4 of these principles into a "Quality Score" (track record, balance sheet, pay-out ratio, and growth prospects) and numbers 5 and 6 into a valuation score. The scores run from 0 to 5 where 0 is poor and 5 is the best. Each of the broad categories has sub-categories which are scored and weighted. We plan to explain this in more detail in a future article.

To illustrate the high-level application of these principles, we have selected three popular dividend paying stocks, Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), and Enbridge (NYSE:ENB). The Quality and Valuation scores are indicated in the table along with other relevant statistics.

As expected, both Coca-Cola and Johnson score well in Quality. Coca-Cola receives a slightly lower score because of deteriorating profitability (although still at high levels) and a higher dividend pay-out ratio. It also scores lower than Johnson on the Valuation metrics, despite the higher dividend yield. Enbridge scores relatively lower on Quality because of a current high debt load. However, the valuation is attractive on all metrics.

All three companies are expected to grow their dividends with more than the rate of inflation over the next 3 years, and all three are currently undervalued compared to our estimate of fair value. We define fair value as the price which will allow investors to earn a premium over the risk-free interest rate which reflects the risk of the investment.

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