While I have been sounding the siren a lot lately about my concerns regarding the balance sheets of many of our largest and most respected companies outside of the Financial sector, I have been all over the concept of "sustainable" dividends for quite some time. In fact, I owe a debt of gratitude to the Seeking Alpha audience for a lot of the feedback that they have shared with me. It was their input that motivated me to launch my second (and my favorite) model portfolio, the Conservative Growth/Balanced Model Portfolio last July. While the challenges over the past 7 months have been immense insofar as investing in a long-only portfolio, it has managed to weather the storm relatively well (- 7%).
I first addressed the idea of looking at sustainabilty and growth of dividends back in May, 2007, which was a couple of months before I became quite bearish on the market. I described a screen that I continue to use with almost the exact same parameters. I followed it up with several updates over the next year. The last one was in July, but there were others in May, March, November 2007 and July 2007. I mention this for several reasons. First, this is an area upon which I have been focused for almost 2 years now. Second, if you review you will find that these stocks on balance have held up better than the market, but they still can and do go down. Third, you might see how I came to view sustainable dividends as more of an offense than just a defense.
As I mentioned, based upon a lot of great feedback from and interest in those articles, I launched a model that would incorporate some of the themes that I had described. I shared in depth with the Seeking Alpha audience my thinking behind the Conservative Growth/Balanced Model Portfolio when I launched in July, and I shared my views on all of the sectors. The last one has back-links to the whole set. I still maintain that if one wants to be invested in stocks (a question worth debating), these are the types of stocks one should own. As I have been discussing at great length recently, the converse is also true: Companies with unsustainable dividends are where one should not be invested. Generally, investors should continue to "Beware Big Bad Balance Sheets".
High debt loads, rising borrowing costs, capital constraints, asset/liability mismatches, slowing or even declining earnings, depreciating inventory, uncollectable receivables, plunging pension assets, useless deferred tax assets, and falling values for assets such as plants, property and equipment will all conspire against many companies who pay big dividends. So, while I have shared some ideas for finding the "good" companies, perhaps it is more important to continue to focus on the ones with the greatest risk.
Whether a company pays a dividend or not, balance sheet issues can wreck equity holders. I have shared many ideas on this front, including looking at all liabilities rather than just "debt", being especially cautious with intangibles, and being aware of debt and bank-line covenants. Today, though, I want to focus more closely on identifying stocks with high dividend yields at greatest risk of cutting their dividends. We have seen several high profile cuts just this week including Dow Chemical (NYSE:DOW) and Masco (NYSE:MAS). That DOW cut its dividend isn't that surprising, but it is remarkable given that it had never done so in over 100 years. My data only goes back to the 70s (click to enlarge):
Many companies are like ostriches with their heads buried, maintaining unsustainable dividends, though the DOW capitulation and the subtle change of tone at General Electric (NYSE:GE) suggest that companies are waking up to the reality of the situation and the need to preserve capital.
Ironically, like a driver speeding up 50 feet before he hits a red light, Vulcan Materials (NYSE:VMC) increased its dividend yesterday. They actually didn't, they just said they did in their press release, which was corrected later. As you can see below, they are still running the proverbial red light, apparently a bit intoxicated.
So, in terms of creating this new screen, let me first say that this is an optimization exercise aimed at identifying those companies at greatest risk of cutting their dividend. I am trying to define what is "high" as well as to capture the parameters that will best identify risk. In narrowing the field, I will omit mentioning several hundreds of names that could face dividend reductions. My focus, too, is on companies outside of the Financial sector. Here are the parameters I employed:
- Universe: Russell 1000 (the top 1000 U.S. companies in market cap)
- Minimum Dividend Yield: 4% (reduces to 224, 140 non-Financial)
- Payout Ratio (Div/Expected 2009 EPS): >70% (reduces to 97, 57 non-Financial)
- Net Debt to Capital: >40% (reduces to 72, 38 non-Financial)
- Tangible Equity/Total Assets: <25% (reduces to 47, 30 non-Financial)
To remove the "duh" factor, I then capped the dividend yield at 11% (so I could include GE still!). Removing all of the Finance names, we are left with 22 (click to enlarge). MAS, by the way, made the list before truncating the extra-high yielders:
A few observations. First, as VMC showed on Friday, not all management teams will act rationally and adjust quickly. Second, as the Spectra Energy (NYSE:SE) stock offering shows, there are ways around cutting the dividend, but selling stock well below where one purchased it last year isn't exactly building value. Third, I included some current ratios as well to highlight additional liquidity issues. There are many companies with short-term liabilities close to or in excess of short-term assets. Fourth, despite chopping the dividend, DOW is still on the list (payout ratio still too high)! Finally, while most of these stocks are pricing in something bad (including possibly a dividend cut), given the declines that average 14%, there are many that aren't down that much year-to-date.
I highlighted some of the names that I am more confident in their propensity to slash the dividend. I don't know the Utilities well enough to comment, and I appreciate that they generally have better ability to borrow. Still some of these may be worth examining closer if one owns them.
Again, in my opinion, this is just the tip of the iceberg. I would guess that over 1/2 the dividend-paying companies in general will cut or eliminate their dividends this year. I can't help but think that there could be an actual benefit (rotation into) to some of the companies with more sustainable dividend policies over the years (low payout ratio, strong balance sheet, high returns on capital), but, in a bear market, it is difficult to expect much on that front. Don't get suckered into a "high" dividend yield, and don't be afraid of a "low" one if it is truly sustainable and likely to grow once we get to the other side of this mountain.
Depressions or terrible recessions tend to wipe out the poorly capitalized companies, leaving a strong future for the survivors. I can't say if this is a good time to be thinking about buying those survivors (probably too early), but I am confident that they will be a better place to invest than the companies that have to reckon with their balance sheet pressures in the coming years.
Disclosure: No position in any stock mentioned, but I am "short" T and VMC (along with WTW and ABX) in a quarterly stock-picking contest.