Dividends Are Not Necessarily a Guaranteed Stream of Income

Some investors, shaken by the markets volatile and often violent downturns, are seeking the shelter of dividends to cushion the impact of market swings. On the surface that seems like a justifiable strategy with the dividend yield on the S&P 500 sitting around 3.8%–a 15 year high; heck, 30-year U.S. Treasuries are only yielding 3.6%.

Not so fast, the stock market’s best dividend yield in 15 years has more to do with the rapid decline in prices rather than substantially increased dividend payouts.  In November alone, 91 companies reduced or suspended their dividends–the most in any one month since May of 1958. This comes on the heels of 81 dividend cuts in October and 60 in September.

This pace may not continue to accelerate the way that it has over the past three months but it does demonstrate that dividends are a management decision and are not a guaranteed stream of income, especially in tough economic times when business is cash strapped.  To be fair, 212 companies have increased dividends this year by a combined $18.4 billion, which is noteworthy but pales in comparison to the amount of cuts, which far outweigh the increases.  There is no doubt cash is king, now more than ever, as companies fear being unable to raise capital if necessary.

It is no surprise that the financial services industry has been the hardest hit in the current crisis. Credit markets have been all but frozen and investment banks are reconstituting their demolished business models. According to Standard & Poor’s, financial companies account for 15% of the stock market but pay out 21% of its dividends. Estimates are that the sub-prime mortgage debacle has cost the industry $972 billion with only $880 billion raised in response up until now.

With formerly revered Wall Street firms failing and being subject to government rescue plans, those financial companies that remain standing are interested in self-preservation, which often means strengthening balance sheets by paying less to shareholders in the form of dividends. So far, dividend reductions by financial firms have accounted for $31 billion; in the previous five years, this sector has only reduced its dividends by a total of $3.1 billion. Not to mention the fact that TARP funding may come with a caveat that limits common stock dividends for a period of time; however, we prefer to look at what is observable instead of speculating on the actions of the Treasury Secretary of an administration in transition.

Firms like Citigroup (C) have all but suspended their dividend (three different reductions over the last year) after receiving $20 billion in government rescue. Bank of America (BAC) bucked its trend of increasing dividends for 30 straight years, halving the amount of those increases in one fell swoop. The New York Times (NYT) last week found it necessary to cut its dividend by 74%. All of these companies presently value preserving liquidity over paying out earnings to shareholders, which is a completely defendable notion as credit has been very tough to obtain.

We would expect this trend to continue until there is a significant improvement in the economy.  But it is not just the “blue chips” that are cutting dividends, as Standard and Poor’s Senior Index Analysts Howard Silverblatt explains:

Financial issues accounted for about two-thirds of the dividend cuts and 93% of the dollar damage during the third quarter. Also, no longer is it just blue chip companies cutting dividends. Many of the issues are now much smaller, and more regional. The problem has trickled down.

Most will remember from introductory finance classes that one common way to value stocks is to consider the stock price as a claim on future dividends. This Dividend Discount Model (DDM) is wonderful for teaching the basic tenets of finance, but it ignores companies that do not pay a dividend and is much too simplistic to put in to practice as we have learned from high growth stocks that shun paying dividends in favor of share buy-backs. For example, the DDM would imply that cutting the dividend is a bad thing for a stock and should decrease its expected price. However, the market has reacted favorably to some dividend cuts, notably when the investment community sees that preserving the capital that would have gone to fund those pay-outs as an essential requirement for a firm to remain well capitalized and to cushion itself in a challenging environment.

So, what does this mean? Essentially, dividend pay-outs are wonderful but they are more at risk now and in the months ahead than at any time in recent memory. Now is not the time to base an investment strategy solely on dividend yield. For investors who depend on income from their investments, this is a fine time to look for high-yielding stocks, but stick to stocks and industries that are unlikely to be forced to cut or eliminate their pay-outs in this rough environment.

One key statistic that an income investor must pay attention to is the company’s payout ratio or the percentage of earnings per share that are paid out  to shareholders as dividends. When a company’s earnings are being compressed–as is commonplace right now–it will likely reduce its dividend in order to maintain its financial health. Furthermore, if a company has a substantial debt burden, it is a more likely candidate to either cut or eliminate dividends.

Of course, the old fundamental rule of investing is true: investing in companies with growing earnings and sales is wise as those companies will be in better position to maintain or even raise their dividend going forward. Such companies are more scarce in this recessionary environment, but they do exist.

Comments

[Anthony Alfidi:]

Analyzing earnings growth is more useful than analyzing dividend growth, as non-dividend paying companies can still have healthy business models. Buying GM or Ford for the dividends would have been a disatrous rationale.

2008 Nov 26 07:58 PM

[hwood007:]

too bad a link did not take us to find all of the latest reductions in dividends.

2008 Nov 27 10:45 AM

[croppled1:]

Please list some companies with growth and possible divdend increases readers ! I found one interesting company but it is in infancy and may need to spend up for expansion rather then increase the dividend . GASS it is also a small cap . Right now I want to target earnings growth plus debt to capital metrics when picking stocks . CCL is one stock I find interesting that has contracting near term growth . Its been below 2001 values and look what happened up until last year when the economy stablized and moved forward . God Bless .

2008 Nov 30 09:49 AM