It hasn’t been easy being a dividend investor of late. As the economy stumbles, companies are shrinking their payouts at a pace not seen in nearly two decades.
Your stocks could be next, particularly if they’re financial institutions. But there are some ways to tell if a dividend cut is in the offing, experts said, and some alternatives for income-hungry investors.
For retirees, dividend cuts can mean a direct hit to income, but they matter to all investors. If you had invested $100 in the Standard & Poor’s 500 index at the end of 1939, without dividends it would have been worth $5,909 by the end of last month, according to Ned Davis Research Inc.
Reinvest the dividends, however, and the portfolio is worth $134,916, Ned Davis said.
All told, 97 companies reduced their dividends in the second quarter, the most since 1990 and a sharp rise from 18 in 2007’s second quarter, according to Howard Silverblatt, senior index analyst for S&P.
Financial firms alone cut dividends by $10 billion in the second quarter, according to S&P. Among them: Citigroup Inc., Wachovia Corp., Fifth Third Bancorp and Washington Mutual Inc.
General Motors Corp. has suspended its dividend, and amusement park operator Six Flags Inc. last month said it will skip its dividend on preferred shares as it struggles with debt loads.
It should be noted, however, that 455 companies increased their dividends in the same quarter, though that number was 16 percent below year-ago levels.
“S&P tracks 7,000 companies, so the vast bulk are still either maintaining or raising their dividends,” said Judith Saryan, manager of the Eaton Vance Dividend Builder fund and co-manager of several other income-oriented funds.
Spotting trouble
How to steer clear of the ones in trouble? Some warning signs crop up when a dividend is vulnerable, experts say.
Look for trends in the dividend yield, corporate earnings growth, the dividend payout ratio and overall debt levels, experts said.
Dividend yield, expressed as a percentage, divides a company’s per-share dividend by its stock price.
When a yield starts to creep to between 8 percent and 10 percent, it’s a red flag, said Josh Peters, equities strategist for Morningstar Inc. in Chicago.
“The market is sending a signal about sustainability at that point,” said Peters, who noted that yields at Citigroup, Wachovia and Washington Mutual all crossed into double digits shortly before their cuts.
Financial institutions have been leading the corporate cutters, and economic downturns or significant events that hit certain industries hard, like the mortgage mess, are another clue that a dividend could be reduced.
Another sign is earnings growth, experts said. Is the rate of earnings increases growing or slowing? Peters compares earnings forecasts with the current dividend to obtain a measure of a dividend’s sustainability.
The payout ratio — the dividend divided by earnings per share — also gives a clue.
Normal ratios vary by industry, but the measure essentially tells investors how much money a company is paying back to shareholders. Higher ratios are more typical in mature industries, while growing companies tend to plow more cash back into the business.
Payout ratios for banks typically range from 40 percent to 60 percent, Peters said. After the mortgage mess, plunging earnings meant that payout ratios in that sector surged above that level, and the dividend cuts began.
Finally, experts said, keep an eye on total debt levels.
As liabilities mount against assets, dividend reductions are a natural corporate finance tool, said Ed Clissold, senior global analyst with Ned Davis. And particularly with financial institutions, assessing those liabilities can become complex because of the huge amount of off-balance-sheet transactions that have become common.
“We now know that companies are as liable for off-balance-sheet debt as on,” Clissold said.
Other strategies
Where does this leave dividend investors?
Locking up cash at today’s low rates on certificates of deposit isn’t attractive. Loading up on dividend-paying foreign stocks increases investors’ portfolio risk. Mutual fund supermarkets have launched income-oriented payout funds aimed at providing regular income to retirees, but the funds have no track record yet.
Still, dividend-loving investors can keep a few strategies in mind, experts said.
“The underlying appeal of dividends hasn’t diminished,” Peters said.
Income for retirees
Dividends are becoming more important for income-hungry retirees as well as investors with longer time horizons, Peters and other analysts said.
S&P dividends per share grew at a 4.2 percent annual rate during the 1990s, according to Ned Davis’ Clissold. Since then, that rate has increased to 6.6 percent, while earnings growth has slowed.
To get a piece of the action and minimize the risk of a sharp dividend cut, think about diversifying the types of dividend-paying stocks you own.
Peters recommends owning at least one or two dozen for diversification, but keep in mind that the more stocks you own, the more work will be involved to manage your portfolio, he said.
Another option is to own a mutual fund or exchange-traded fund that focuses on dividend-paying stocks. As with other fund investments, you need to watch expense ratios closely and choose carefully whether you want to pay for active management of the fund.
Active managers in dividend-focused funds can use more complex strategies for harvesting dividends, said Saryan, the Eaton Vance manager.
“It makes a lot of sense to look at equities for income because they represent a much better inflation hedge over time,” she said.
Want out of dividend strategies altogether but still need regular income and can’t stomach the low returns in Treasuries?
Managed payout option
You might consider the managed payout funds being offered by the major mutual fund supermarkets such as Vanguard and Fidelity. The funds focus on paying out income on a regular basis but invest in an underlying broad portfolio that isn’t dividend dependent.
Saryan thinks staying focused on a broad mix of dividend-paying stocks will be rewarded, both for retirees and younger investors.
“We’ve focused on consumer names like McDonald’s, which has had great dividend growth; Wal-Mart and CVS, which have strong cash generation,” she said.
“The bottom line is to look for a [fund] manager who isn’t just focused on yield but on companies whose boards of directors are raising the dividend every year. That’s the signal that the board has confidence in the stock.”
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Drying up
Here are warning signs that a company’s dividend may be in danger:
* The company has a high payout ratio (the dividend divided by earnings per share), particularly if earnings are volatile.
* The dividend yield (the annual dividend divided by the stock price) is substantially higher than peers. Double-digit numbers raise concerns about sustainability.
* The company has lots of off-balance-sheet transactions. These deals can have a material impact on debt levels, and thus the sustainability of dividends.
* The company has slowing earnings growth relative to total assets.
SOURCES: Analysts; portfolio managers at Ned Davis Research Inc., Morningstar, Eaton Vance
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Janet Kidd Stewart is a Your Money columnist.
