Dividends are back in style again, and with S&P 500 payouts forecast to hit records in the current quarter, it’s an excellent time for investors to dig into what makes a dividend sturdy.
Actually, it’s always a good time for that quick homework because as the 2020 coronavirus bear market taught investors, some dividend-paying firms don’t have the strongest of balance sheets. When times are tough, as they were in the first half of 2020, those companies will suspend or trim payouts to conserve cash.
Yet there are strategies for investors to avoid that fate. One factor to consider is a company’s competitive moat.
“For example, for 2020, Dan Lefkovitz from Morningstar’s indexes group looked at dividend-paying company stocks, dividend-paying companies around the world, and looked at those that had cut their dividends and those that hadn’t,” says Morningstar Investment Management Editorial Director David Harrell. “And he’s found a very strong correlation. So the wide-moat companies were the least likely to have cut their dividends. The no-moat companies were the most likely to have cut their dividends, and the narrow-moat companies came in between.”
Not only that, but wide-moat companies were more likely to have boosted payouts over the prior three years, while no-moat companies were the least likely payout boosters and the most likely dividend offenders.
Drilling down into more specific financial factors for investors to evaluate when pondering dividend durability and growth prospects, not surprisingly, cash, as in cash flow, is king.
“So you want a company with a strong balance sheet. Typically, you don’t want a firm that is highly leveraged, that has a lot of debt, has a lot of interest expense relative to operating profit. So that’s something to look for,” adds Harrell.
A specific ratio to consider is the payout ratio, which is annual dividend paid divided by the earnings per share. For example, a company that has an annual payout of $1 per share and earns $10 a share has a payout ratio of 10%.
“In general, there’s a couple of ways to think about the payout ratio. Certainly, if a company has a low payout ratio, that means it’s devoting a relatively small portion of its earnings to dividends, so there’s room to grow,” adds Harrell.
Not all high payout ratios are bad. Some could be simply be the result of a company being devoted to dividends, but when investors come across elevated payout ratios, they should closely scrutinize a company’s balance sheet to guard against the potential for negative dividend action.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.