3 Signs of a Healthy Dividend

Susan Dziubinski:

Hi, I'm Susan Dziubinski with Morningstar. Many investors rely on dividend stocks for income. So, how can they figure out which dividends are stable, and which may not be? Joining me today to discuss a few factors dividend investors should consider is David Harrell. David is an editorial director with Morningstar Investment Management and editor of

Morningstar DividendInvestor.

David, thank you for being here today.

David Harrell:

Thanks for having me.

Dziubinski:

One factor that Morningstar says contributes to dividend stability is an economic moat. Can you tell us a little bit about Morningstar's Economic Moat Rating and then bring that to the relationship with dividend stability?

Harrell:

Sure.

Economic moat

is a phrase that Morningstar analysts borrowed from Warren Buffett of Berkshire Hathaway. And it's basically a way of thinking about or visualizing a company's ability to defend itself from competition. No company exists in isolation. You have a firm that's earning high rates of return on capital. All else being equal, you would expect its competitors to eventually sort of compete that advantage away. Morningstar analysts look at a number of moat factors, which they think contribute to a company's ability to hold off competition. And if a company has enough of those factors that they can hold off or the analysts believe they can hold off competition for 10 years or more, they would award that company a narrow moat rating. If they think they could sustain competitive advantages for 20 years or more, they would award it a wide moat rating.

Now, a moat rating does not guarantee dividends, of course, but we have seen some very strong correlations between economic moats and dividend sustainability. For example, for 2020, Dan Lefkovitz from Morningstar's indexes group looked at dividend-paying company stocks, dividend-paying companies around the world, and looked at those that had cut their dividends and those that hadn't. And he's found a very strong correlation. So the wide-moat companies were the least likely to have cut their dividends. The no-moat companies were the most likely to have cut their dividends, and the narrow-moat companies came in between. And this echoes something I found a few years ago: I was looking through the Morningstar universe of U.S. companies and found the exact same correlation. Wide-moat companies over the previous three years were most likely to have increased their dividends, the least likely to have decreased them. And no-moat companies were the most likely to have cut their dividends and the least likely to have raised them. So again, it's no guarantee, but having a wide moat seems to point to income or sort of stability of earnings that is going to--you're not going to have sort of an earnings crunch that would force the firm to cut or suspend its dividend.

Dziubinski:

Now strong finances is another thing that, you know, dividend-seekers should be looking out for if they're trying to find stocks with durable dividends. What specifically should they be looking at?

Harrell:

Well, if you think about the dividend payment--as cash flows through a corporation, dividends sort of come at the end. So you want a company with a strong balance sheet. Typically, you don't want a firm that is highly leveraged, that has a lot of debt, has a lot of interest expense relative to operating profit. So that's something to look for. It's also important to look at a company's history and maybe over an entire economic cycle. How has it held up during a previous economic downturn or even as sort of an industry- or sector-specific crisis? Has it been able to maintain its dividend during that time period? So there I would look at perhaps the five-year dividend growth rate, annualized dividend growth rate, to see if the company has a strong history of being able to increase its dividend.

And finally, I would consider the management and board's attitude toward the dividend. Are they very supportive of the dividend in their capital allocation decisions? Or are things like buybacks or share repurchases of greater importance to that firm? And there's a number of things you could look at, even the shareholder letter. Do they tout the dividend? Do they tout the dividend record that x number of years of uninterrupted dividend growth or uninterrupted dividend payments? Maybe read the transcripts of the quarterly earnings calls. There'll often be questions there about the dividend, and it's a good way to see what management is thinking. Again, it's not a guarantee. But if you have a corporate culture in place where management is very supportive of the dividend, I think those firms, if they do have sort of an earnings crunch, are going to be less likely to immediately suspend or cut their dividend.

Dziubinski:

Now another factor to look at is the payout ratio. Tell us a little bit about what that is.

Harrell:

The payout ratio is very simple math. It's simply the annual dividend paid divided by the earnings per share. So you have a firm that's paying $1.50 per quarter in dividends at $6 a year. If that firm had earnings per share of $10, you'd have a payout ratio of 60%.

Dziubinski:

Then is a low payout ratio always a sign of a healthy dividend?

Harrell:

In general, there's a couple of ways to think about the payout ratio. Certainly, if a company has a low payout ratio, that means it's devoting a relatively small portion of its earnings to dividends, so there's room to grow. Also, you can think of the payout ratio as sort of a safety factor in that--take a hypothetical company with a 60% payout ratio. In theory, that firm's earnings could drop by 40% and it would still be able to maintain its current dividend. But when looking at payout ratios, I think it's something you want to look at in context to both the firm's history and then other companies in the same sector or industry. Certainly different industries, you'll see different trends in payout ratios--something like utilities, you're more likely to see higher payout ratios.

Certainly a firm could have a high payout ratio. And that might just simply indicate that this is a management team that's very devoted to returning cash to shareholders via the dividend. And it might seem high by itself. But if the earnings appear stable and there's low debt, they can certainly continue to increase that dividend, even with a current high payout ratio. And then also keep in mind what sector you're looking at. Because something like real estate investment trusts, for example: The payout ratio probably isn't the best metric to look at for dividend sustainability. There, you will look at something called

adjusted flows from operations.

So, think about the payout ratio, what sector you're looking at, and then relative to other firms in that sector. So if you see something that's quite a bit higher then that might be more of a cause for concern, but think of it in context.

Dziubinski:

And then lastly, are there any other factors that we haven't discussed that dividend investors should be thinking about or looking at when they're trying to assess a dividend's stability?

Harrell:

Well, I think if you're looking at dividend stocks, it's very tempting to take a stock universe and rank it by yield from highest to lowest, and then get excited about some high yield numbers, like 6%, 8%, 9%. And I just caution anyone to be very careful there. Because why is the yield so high? Is it because the dividend rate has just zoomed up? It's more likely, when you see those high yield numbers, it's because the stock price has cratered because yield is simply the dividend divided by the stock price. And if you've seen the stock price plummet, there's probably a very good reason for that--that investors are very concerned about a firm's earnings and its ability to continue to fund that dividend. So, my caution there is certainly you might find a company that looks appealing based on the yield number, but you can't stop there because you don't want to get a trap there where your 6% yield turns into 2% or 3% when that firm is forced to cut its dividend.

Dziubinski:

Well, David, thank you so much for your time today for helping us suss out where we might be able to see what is a dividend grower and what might not be as likely to grow or even be stable. We appreciate your time.

Harrell:

Thanks for having me.

Dziubinski:

I'm Susan Dziubinski with Morningstar. Thanks for tuning in.