Portfolios built for dividends should be, at least partly, evaluated based on debt management and debt history.
Companies that are averse to debt are sending a signal to investors that financial health is important. What that means is that I think debt is bad for shareholders and in general I view debt to be negative. In specific cases I can see debt has really made a positive difference. In many many cases it has capsized companies, and the debt effect is an important measure of good management. Well run business are getting out of debt and need less and less debt to purchase growth, or in some cases the debt structure is well managed and stable, this is the case with AT&T (T) and some utility companies. Let's look at some non-utility debt situations that turned out very positive and were throwing off all kinds of signals for buying opportunities. All charts from www.ycharts.com.
Apple (AAPL) is a good example of all this and should be considered as a part of a debt averse portfolio. Apple's long term debt is shown in blue and earnings per share in orange in the chart below.
Apple is an extreme case. Innovation has added a group of product lines that have been well received to say the least. Apple eliminated long term debt in 2004 and have not looked back. Some very good decisions were made with the excess capital being generated by sales. The iPod became the iPhone and the rest is history. Once debt was gone the profits were invested in growth. Shareholders were well rewarded with the rising stock price, and now a dividend.
Whole Foods Market (WFM) is another great example. Below is a 10 year chart showing long term debt (blue) and earnings per share (orange).
Whole Foods had worked their way to a market cap of about $5 billion and free of long term debt in 2007. The company made an acquisition of a close competitor at the end of that year. It was done with $800+ million in debt. The impact to EPS is pretty clear (plus the recession), the dividend was suspended to handle the debt reduction plan. In the case of Whole Foods you can see that the debt adverse culture has been a great benefit to shareholders. The next chart simply has the share price shown on the same chart as above.
Whole Foods 10 year Chart with Stock Price in red.
A historical knowledge of company debt management and some careful thought would have uncovered a nice opportunity to buy this stock. This is not a case like Apple where innovation changed the sales universe, this is just a solid move. Whole Foods re-initiated their dividend in 2010 as well (see story here).
Another example to drive my point home.
Aaon (AAON) is an air conditioning equipment manufacturer based in Oklahoma. These guys have a nice product and price point. In the durable goods market that is a nice combination. The culture at Aaon has always been debt adverse. To save time I put Long Term debt, EPS and share price on the same chart. Let's take a look.
It never takes long for the reduction in debt to signal a rise in EPS. Please note the upward move in earnings per share in 2007-2010. Yes that does include the great recession. I believe some of the earnings move from Aaon was because builders were facing tighter budgets starting in 2007/8. I'm sure the larger portion of those earnings increases were from the effect of some well invested debt from 2005. That debt was eliminated in 2007. Aaon began paying shareholders a dividend in 2008, and since retired the next round of debt by 2011.
Debt is certainly not the only thing to consider in a complicated and noisy equity market. Debt culture will tell you a few things about a company, one of those things is the management regard for shareholder value. Furthermore, low debt does not mean you are about to get rich as a shareholder, but in portfolio creation, being debt adverse reduces the overall risk to the portfolio.
These three companies are on my watch list and may be added to client portfolios at any time.