How to become a better income investor.
In 2008 and 2009, the dividend landscape was turned upside-down. All told, 202 UK companies cut their dividends in 2009 alone, whilst 60 more froze their payouts -- costing investors £1.3 billion, according to data from Capita Registrars.
In the US, where I'm based, 1,092 companies cut their dividends over the past two years. Suffice it to say, dividend investors on both sides of the pond have seen better days.
Nevertheless, amid all the dividend cuts and suspensions, we were reminded of five key lessons that we can use to our advantage going forward.
Lesson 1: Share dividends are a privilege, not a right
The first and most obvious lesson -- that dividends are not guaranteed -- was also a truism most people ignored in the years leading up to the dividend crisis. But unlike interest from bonds and savings, a company's board of directors must choose whether or not to pay out cash dividends to shareholders.
There are obvious incentives for a board to maintain or increase regular dividend payouts -- it helps attract income-minded investors and is a sign of financial strength -- but in times of severe uncertainty, particularly in a credit-driven panic like we had, cutting the dividend to raise or preserve cash becomes a more attractive option for companies. This is exactly what pharmaceutical giant Pfizer did last January, when it cut its dividend in half to support its acquisition of Wyeth.
When one company cuts its dividend, it usually signals an inability to manage its finances. That cut becomes a scarlet letter for the firm. As we saw over the past two years, however, if many companies are in the same boat, the stigma of a cut is lessened, making it a more attractive option for cash-strapped boards.
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Lesson 2: Beware of chasing high yields
Over the past decade, with interest rates and market yields relatively low, income-thirsty investors were forced to go further up the risk ladder to find agreeable yields -- and many paid the price during the credit crisis when those riskier investments failed to maintain their historical payouts.
A good rule of thumb is to be sceptical of any dividend yield more than two times the broader market average (currently 3.3% for the FTSE 100, so be wary of 6%-plus). Anything over that amount implies that either the market has concerns about the company's ability to grow, or the share price has fallen sharply for good reason.
I'll use another US example here. In June 2008, Bank of America had a yield greater than 10%, at a time when the US market average was around 2%-3% -- a good indication that the dividend was anything but assured. No prizes for guessing what happened to that payout.
Lesson 3: Focus on cash, not earnings
Whilst earnings are an accountant's opinion, cash is fact. Without enough actual cash to pay the dividend, the company must fund it with either debt or by selling shares -- neither of which is sustainable.
To determine whether or not a dividend is sustainable, first look at cash flow from operations going back five years or more. Then subtract capital expenditures (investments in property, buildings, and equipment) from each of those years.
Whatever is left over can be considered 'free cash flow', which the company can use to pay dividends or repurchase shares.
Next, look further down the cash flow statement and see how much the firm paid in cash dividends each year. If that figure is consistently less than free cash flow, it's a good sign that the firm has enough cash to maintain its current dividend.
Three names on the FTSE 100 that fit this bill today are:
|Pearson (LSE: PSON)||3.6%||36%|
|Imperial Tobacco (LSE: IMT)||3.4%||19%|
|Diageo (LSE: DGE)||3.4%||49%|
*Data provided by Capital IQ, as of 5 March, 2010.
Lesson 4: Diversification still matters
It's true that many sectors experienced dividend cuts over the past two years, but none were hurt as much as the financial sector. In the States, financials at one point made up 30% of all dividend income from S&P 500 members. That's now down to 9%, according to S&P analyst Howard Silverblatt. In the UK, the story has been much the same.
But despite the gloom in financials, 33 of the 34 dividend actions taken by consumer staples stocks in the S&P 500 last year were positive, serving as evidence that not every sector suffered equally.
A dividend-focused portfolio that was diversified across sectors still likely took a hit during the financial crisis, but less so than one heavily exposed to financial stocks for their higher yields. That's why sector diversification matters, even if you need to sacrifice a little yield in the near-term.
Lesson 5: Selectivity is paramount
Because dividend cuts can be wide-ranging during a financial crisis, your best bet is to hand-select a diversified group of strong dividend payers, rather than assuming that dividend-themed indexes and ETFs will save you.
For example, the iShares FTSE UK Dividend Plus (LSE: IUKD) has a stated goal of holding "approximately 50 of the highest dividend paying UK stocks," which, leading up to the crisis meant holding substantial positions in financial firms like Lloyds Banking Group (LSE: LLOY) and Barclays (LSE: BARC). Unsurprisingly, after those high yields were slashed the ETF's dividend payouts have also fallen sharply.
Wrapping it up
The five keys to successful dividend investing will help you build a diversified portfolio of hand-selected dividend payers with above-average but modest yields, well-covered by plenty of free cash flow. Pair this group with high-quality bonds and you'll have built yourself a well-rounded income-focused portfolio that can help you achieve solid profits without undue risk.
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