Techniques to Avoid Dividend Cuts

In my last article, I’ve covered What is a Dividend Trap. So you can avoid a future wave of dividend cuts, I’d like to offer you my three favorite techniques to avoid them. They have been proven to be highly effective in the past. Beside a few exceptions (mostly due to the nature of the exceptional economic lockdown we suffered), we were able to avoid most of the dividend cuts at DSR.

The following is a short and applicable list of actions you should take with your portfolio this summer. There is nothing like hanging around a pool and optimizing your portfolio. Volume will be lower, volatility will take a pause, and it will be time for your to take a deep breath and make sure you don’t suffer from additional cuts this fall.

#1 Trust the market – beware of high dividend yield stocks

My first indication that something is wrong is usually the market action itself. While I don’t rely on it, there is still some truth speaking from the action in the market. When a sector or most of the market follow the same movement, it’s difficult to understand exactly what the market is telling us. However, when you see companies that are getting beaten down more than others, this is normally a sign that something is wrong.

At this point, many companies have seen their stock prices recover partially or fully. Companies that are still down by 30-40% and haven’t cut their dividend yet will offer you astronomic yields. Don’t fall for the yield trap, because this is what it is very likely to be.

If you have been reading my work for a while, you already know I’m not keen on high yielding stocks. High dividend yielding stocks (5%+) often offer either a higher degree of risk, poor growth perspectives or most likely both. Since I’m not looking for an immediate source of income, I don’t have to bother with high yielding stocks. However, whenever I hold a stock where the yield goes over 5% like Enbridge (ENB), I will pay more attention.

Not all high yield stocks are bad investments. You will find some interesting picks among this category. Here are a few examples.

The ratings you see in the table below are based on the ranking system we built at Dividend Stocks Rock. The PRO rating gives a score from 1 to 5 “stars”, 5 being an exceptional buy (everything is there; a strong business model, several growth vectors and an undervalued price). The Dividend Safety Score tells which kind of dividend policy to expect, 5 being that past, present and future dividend growth perspectives are marvelous.

You don’t have to follow the same ratings, but I will never insist enough on the importance of having a ranking system for your portfolio.

This is not an exhaustive list, but rather just a few examples of great companies offering a higher yield than normal. I’m the first to be surprised to count some Canadian banks on that list (CM is showing a yield over 6%).

The point here is not to completely avoid stocks with a yield greater than 5%, but rather not to concentrate your money into that type of higher risk holding. Remember; there is no free lunch in finance. There are reasons why those companies are “so generous”. One must follow those companies closely and make sure to review each quarterly report with serious attention.

#2 Avoid stocks with an absence of dividend growth

As the inflation rate hasn’t been excessive over the past 10 years, most income seeking investors don’t factor inflation into their investment decisions. Many tell me, “Mike, I’m retired, and I need this 8% income, I don’t care about inflation”. I can understand that position if you have $1M invested at 8% and you only need $60k/year to live. This means inflation can eat up $20,000 per year in dividend income before it affects your lifestyle. That may make sense to some folks.

The problem is that many companies that keep their dividend static will eventually cut it. If management can’t increase its payout when the economy is growing, what will happen during a crisis? You are correct – they will be among the first to cut their dividend. I tried to find companies where they were showing growing revenues and earnings but with no dividend increases over the past 5 years. They are rare. In fact, most “non-increasing” dividend paying stocks will eventually look like this:

Source: Ycharts

Before telling me H&R REIT cut their dividend because of the covid-19, please keep in mind that the company also had to cut it back in 2009. In fact, this is pretty much a copy/paste scenario of the last crisis. In the early 2000’s, the REIT grew for about 10 years and then cut its dividend by 50% to preserve the business. 10 years later, we see the same scenario evolving.

If you go back to your portfolio now and look for companies that haven not consistently increased their payouts between 2015 and early 2020, chances are they have reduced their dividends, or they are already priced for a cut. It’s time to act now and look at which holdings would do a better job with what is left of your capital. Don’t wait for a full recovery as it will be a painful path that will only lead to more losses.

#3 Weak dividend triangle

You know that by now the dividend triangle is a very strong indicator when it comes to assessing the likelihood of a dividend cut.

The Dividend Triangle is composed of three metrics:

Revenues: A business is not a business without revenue. What is the difference between a company enjoying a growing revenue stream from a company showing stagnant results? More often than not, the difference is in the competitive advantages that firm enjoys over its competition.

Earnings: You can’t give money to your shareholders if you don’t have earnings. Then again, this is a very simple statement. Still, if earnings don’t grow strongly, there is no point in anticipating that the dividend payments will increase indefinitely.

Dividends: Last, but not least, the dividend payments are the *obvious* backbone of any dividend growth strategy. I don’t focus on the dollar amount or the specific yield as my sole focus is on dividend growth.

Companies losing market share due to the lack of competitive advantages will see their story through their revenue trends. It is very rare to see any business publishing growing revenue year after year. For many reasons, a company could publish weaker results. It could be the end of a cycle, a change in the business model, or simply the economy slowing down. However, if this situation persists for several years and management can’t find growth vectors, the red flag must be flown.

The same logic applies to earnings. Since earnings calculations are based on GAAP, we are not talking about real money. This number is far from being perfect. In fact, you are better off combining it with free cash flow or cash flow from operations to see what is really going on. Nonetheless, if a company is unable to generate growing EPS over a long period of time (5 to 10 years), chances are dividend growth will not follow.

Finally, as I discussed earlier in this article, a lack of dividend growth is a sign there is a problem that must be investigated. When management is confident enough to raise their payouts by 4-5% or more each year, I can sleep well at night and I really don’t mind what is happening in the market. Sooner or later, the market will bounce back and dividend growers are among companies that will thrive.

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