The dividend strategy is one of the most popular investment strategies. Presumably, this is because the very idea of buying quality shares that increase dividends year by year is relatively easy to understand. There is a lot of literature on the subject. And, one gets ongoing confirmation that the strategy "works" through dividend payments. In this post, I'll explain how to think like a dividend investor and hopefully correct some of the most common mistakes made in dividend investments.
The basic misconception about dividends
People who are new to investing often ask questions such as:
"Should I buy the stock before or after the last payment date?"
"Where to find the shares that pay the highest dividend?"
But what is really a dividend and what does it tell us about the company's situation?
Here I explain dividends from an accounting perspective. When a company makes money and gets a positive result on the bottom line, they have more options on how to spend that money. This added value means that the intrinsic value increases. Therefore, already before an alternative dividend has been paid, the company has already received a higher intrinsic value as a result of the increased money supply.
So what happens if they pay dividends?
This "money supply" is reduced and the internal value falls. This means that dividends in themselves are not what give value to a company, but it can be a driver.
Why dividends are a driver, but not a value
In my portfolio, only profitable companies with increasing dividends are found:
This is one of the most important elements of thinking as a dividend investor and part of what makes it so valuable. You invest in companies with solid business models, and they make good money rather than companies that can make money if things go as they should.
In order for the company to succeed in increasing its dividends, they must be able to create value over time. This means that they must become profitable, more innovative and competitive. Therefore, dividend growth can be seen as an effect of good business activity, which in turn is why the strategy itself works.
The difference between American and Nordic dividend companies
The main difference is that Nordic companies pay dividends based on the last operational year or the last 6 operating months, while US companies use set dividend targets.
For American companies, cutting the dividend is one of the last things to do as dividends in themselves are a measure of operational stability and promising prospects. As they increase dividends, this is understood as a direct message from management that they expect to earn more in the future.
For Nordic companies, this means that having years with constant or increasing dividend payments is difficult. There will be demanding business years with stock market crashes, recessions, and poor earnings. It is precisely this stability of dividends that makes many favor American stocks.
The problem with lists such as dividend aristocrats and the story of Kinder Morgan
What can happen? Well, the story of Kinder Morgan (NYSE:KMI) highlights the topic well:
Kinder Morgan was the largest energy infrastructure company in the United States and owned 128,747 km of pipelines to transport oil and natural gas. On December 4, 2016, the Kinder Morgan management told shareholders that the free cash flow per share would be:
"consistent with previous guidance of 6 to 10 percent above the 2015 dividend and it would be sufficient to support dividend growth in the range discussed in the third quarter call"
So a dividend growth of around 6% to 10% and 3 months before this, they increased dividends by 16%.
Unfortunately for Kinder Morgan's shareholders, a bear market happened. A sudden fall in energy prices led to momentarily higher costs and complex liquidity problems. This meant that Kinder Morgan had to cut the dividend on December 8. This was only 4 days after they said that dividends were safe. Consequently, the stock price halved and the dividend record of the company was abruptly terminated.
What does Kinder Morgan's story show?
That companies, occasionally, are valued based on how much dividends they can pay or their latest dividend increases. Not the free cash flow, rather how generous they are. The story clearly shows that the quotation below is true.
"The safest dividend is not always the one that has just been raised"
The search for the highest yield
New investors often start hunting for high yield stocks. You should instead be looking for solid quality companies that over time can create value. In the first section, we looked at what really happens to a company when it pays dividends, and this provides a good basis for discussing high dividends.
Imagine being a business owner
Imagine you own a business and you paid a high dividend the previous year. This year business was bad so you earned less than what you did last year, making you have less money.
Not only do you have less money to hand out, but some of your inventory was destroyed so you have to buy more at the same time as the loan interest rate has gone up.
Therefore, you are facing a problem - should you raise loans to pay dividends so that the shareholders do not experience a "dividend cut" or should you reduce dividends so that you get more flexibility to ensure long-term good operation?
If one thinks about the case as a long-term business owner, then one wants the company to have flexibility. In order words, the most room for maneuvering, because this provides a good basis for long-term value creation.
So, if you hunt companies that pay very high yields (over 10%), then it is likely that at some point they are facing a dilemma as described above.
Cyclical companies often operate in volatile sectors. Shipping is a typical example. Here, shareholders experience dividends of 25% one year only to experience several months and years of flat price development and little value creation.
The shareholders are thus caught while the company is trying to keep the balance in order. As you can see, I got a very good dividend in 2016 from BW LPG (OTCPK:BWLLF) (OTCPK:BWLLY), but the course never came up. A good lesson.
How to avoid dividend cuts
A solid dividend portfolio should look like this:
- 50% defensive shares (consumption, telecom)
- 25% cyclical (finance, "luxury goods", real estate)
- 25% sensitive (industry, energy, and technology)
I recommend several sites to analyze dividends: Børsdata, SimplySafeDividends, and Valuentum.
Dividend payment share/payout ratio: The share of dividend payment in relation to how much the company has earned. The rule of thumb is below 70% for most companies.
Debt to equity: How much debt the company has in relation to equity. The lower the ratio, the better. But one should strive for numbers below 4.0, preferably around 2.
Net debt to EBITDA: How many years of earnings it takes before the company manages to repay its debt. The lower the better. But you should strive for numbers less than 5.
Dividend Cushion: Valuentum is a backward and forward-looking way to analyze the security of dividends.
Finally, it is worth mentioning that one should strive and find companies that understand that we as shareholders are their partner and they work for us.
Although one would think that this is the standard, it happens that the management forgets that the shareholders should both be informed and have their share of the cake.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.