Two Keys to Avoiding Dividend Cuts

With interest rates on bank CDs, Treasury bonds, and other minimal-risk investments being very low, I can understand the almost visceral appeal of a stock carrying a yield of 10%, 12%, or even 15%. Those who rely on their portfolios to pay the bills would probably find that extra income awfully handy. But I've noticed a troubling pattern--both in my three-plus years of editing Morningstar DividendInvestor and my 18 years as an individual investor: Sky-high yields are a warning sign. As attractive as a double-digit yield might seem, what you see today might not be what you get for much longer.

This is no small risk for investors, whether they're relying on the income to pay their bills or not. Take  National City , for example. At the end of December, the stock appeared to carry a 10% yield. To someone starved for income on bank CDs, the firm's common stock might have seemed to offer a much better prospect. But that yield didn't last long--on Jan. 2, National City cut its quarterly dividend from $0.41 a share to $0.21. Three months later, the bank declared a dividend of just one cent a share. An investor who bought 100 shares of National City for $1,646 could have originally expected $164 worth of annualized income. He or she now stands to get just $4. And not only did that income stream all but vanish, but the stock price got clobbered--recently National City shares have been trading for about $6.

Picking winners is good, but much of an investor's overall success depends on avoiding losers like National City. Fortunately, dividend cuts can be avoided. The two most critical keys in this regard are know what you own, and listen to the market.

Know What You Own
Dividends send very valuable signals. To pay a cash dividend, a company naturally has to have cash on hand, so the dividend-seeker is starting out with a group of businesses that are much more likely to be solvent than not. A dividend increase is an even better signal, precisely because companies don't like to cut their dividends. They're not likely to issue an increase today that will lead to a decrease tomorrow.

By itself, however, a favorable dividend record doesn't mean much. Dividends are paid out of earnings and supported by an adequate capital base. So if you're going to buy a stock for its dividend (or for any other reason, for that matter), you've got to know how those earnings will stand up under duress. This is why I begin with dividend safety every time I start work on a particular stock. Every company and industry has its own special circumstances, but I can share some key factors well worth considering:

• Financial leverage and liquidity. The obligations of a heavy debt load compete with dividends for the company's resources. If cash flow runs low, creditors must be paid first--and the dividend may have to be sacrificed to save the firm from insolvency.
   
• Operating leverage. Most companies' revenues are subject to some kind of cyclicality, whether it's tied to the broad economy or not. In a downturn, whether industry-specific or the result of a recession, revenues might decline. How this will affect profits is a function of operating leverage--the relationship between fixed and variable costs. A highly variable cost structure helps minimize the threat of revenue changes on the bottom line, while high fixed costs exacerbate it.
   
• An economic moat. Competitive threats can savage a company's profitability without much warning. That's why I require one or more sustainable competitive advantages--what we at Morningstar refer to as economic moats--around any business that I would buy for income.
   
• Room to grow. A company that has little or no prospect for earnings growth over the long run might have maxed out its ability to pay dividends already. The next change in the firm's fundamentals might well be for the worse.

Listen to the Market
I'm no proponent of efficient-markets theory. Actual experience demonstrates that short-term stock prices are wrong all the time. Nevertheless, a stock carrying a double-digit yield is trying to tell you something: That dividend may not hold up much longer. Virtually no stock can be assumed to deliver 12% or 15% returns in perpetuity, much less on income alone. So even though many (if not most) market participants are paying attention to earnings rather than dividends, a reasonably stable and reliable earnings stream is required to fund those dividend payments. If earnings are falling fast, the stock price is often marked down accordingly. And as a stock's price falls, its yield rises--at least until the per-share dividend rate changes for the worse.

This is why I've come to see 8% as marking a demilitarized zone of sorts. If the stock carries a yield higher than that, you've got to have a very high level of confidence in the underlying cash flows of the business and management's willingness to maintain the dividend rate even when it might not seem convenient or rewarding. Yet, such confidence is very hard to come by: Economic moats around such stocks are very rare, operating leverage tends to be very high, and so does debt. These days, specialty financial stocks like  iStar Financial  and  Newcastle Investment (NCT) are perhaps the best examples of this phenomenon. These stocks may have speculative appeal, and if their dividends aren't cut, the investor stands to be handsomely rewarded. But whatever its other failings, the marketplace isn't being stupid: It's flagging a huge amount of risk, specifically to the dividend.

In an ideal world, income investors would be able to escape from perilous situations well in advance. I once owned National City, but I sold it for $37 a share in January 2007--a full year ahead of the dividend cut. Even though I didn't see the cut coming, I couldn't help but notice how poorly the bank was performing when its regional peers were practically printing money. By acting well in advance, I was able to redeploy my capital into stocks that proved to be much more reliable earners. In other situations, I haven't been quite so fortunate. But by avoiding almost all sky-high yields in the first place, I've saved myself a lot of grief.

The Bottom Line
Since launching DividendInvestor in January 2005, my prejudice against sky-high yields has served me well. Even though I own stocks with yields in the 3%-8% range, my holdings have provided 115 separate dividend increases amid only one dividend cut.

Even in an environment where dividend cuts are becoming almost commonplace, I remain as big a fan of dividends as ever. If you can avoid stocks that wind up cutting their dividends, you can craft a portfolio that will provide good cash returns regardless of market prices. (Remember that dividends, unlike fickle capital gains, never have to be given back.) Now there's a formula for a good night's sleep, now or anytime.

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