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On Wednesday, supermarket chain operator SuperValu (SVU) reported earnings that missed by $.19. SVU finished the day down 49.15%.

SuperValu's incredible plunge should serve as a free warning to those fortunate enough to avoid it: don't accept the risk of capital loss in exchange for a big dividend yield.

Before the plunge, SVU was "rewarding" shareholders with a near 7% yield. Meanwhile, the company has been servicing $6.26 billion in debt (relative to its $560 million market cap, and $1 billion in annual losses), giving it an unseen debt to equity ratio of almost 30,000%.

The Implication For Dividend Investors

Dividend investors need to recognize the necessity of capital preservation. Absolutely no yield is worth the financial pain that one experiences as a result of a decline like this one. Whether it's Greek debt (yielding 24%) or a company with a weakening business model and excessive debt load like SVU, investors need to determine the incurred investment risk before any consideration of yield.

For a classic dividend investor (note: not a speculator), we would like to see the following criteria met:

  • Management has cautious and intelligent approach regarding leverage: excessive debt to equity ratios or absurdly high returns on equity are indicators of excessive debt. Additionally, the total net debt (debt - cash) should only be two to three years worth of annual net income.
  • Management has a history of solid earnings retention: This means that for every dollar management has retained (not used for dividends), it has grown earnings per share by a reasonable amount.
  • The business has at least moderate barriers to entry or operates in a niche market: It's amazing how businesses can erode without anyone really noticing, and then the stock loses half its value in one trading session. The deterioration in SVU's business has been occurring over the past couple of years, largely a result of dollar stores like Dollar General (DG) selling discount groceries and nipping at market share.
  • Very reasonable payout ratio based on consistent free cash flows: this speaks for itself. Payout ratios relative to FCF should be no higher than 80-85%, and free cash flows should be consistent and growing over time.

Conclusions

There are of course other criteria, but companies that meet these guidelines can generally be considered to be very safe from a long-term capital preservation standpoint. "Reaching" for yield, or accepting low-quality fundamentals in exchange for lofty dividends is an extremely risky investment strategy; SuperValu's massive plunge should be used as a learning opportunity for everyone.

Source: The Dangers Of Reaching For Yield: Supervalu Gets Pummeled