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By Holly Cook and Todd Wenning, CFA| 6-11-2013 8:00 AM

Watch Out for These Signs Of a Dividend in Danger

Morningstar's Todd Wenning tells us his list of important signs to watch out for if you own a stock for its dividend

Holly Cook: Dividends can be a great source of income, but how do you know if your dividend is in danger? Joining me to answer that question is Morningstar equity analyst Todd Wenning. Todd, thanks very much for being here. 

Todd Wenning: Thanks for having me. 

Cook: So, I know that you're a bit of an obsessive about dividends and stocks and you look at the UK a lot. Why don’t you tell us first off, what is one of the key signs to look out for if you're concerned that your dividend may be in danger? 

Wenning: Sure, so one of the things I look out for when a dividend is possibly in danger is stalled dividend growth. Now, when companies increase their dividend payouts, they're signalling to the market that they think they can pay that amount going forward, that means they have confidence in the business. That dividend growth stalls when they stop raising the dividend, that means that internally, the board is discussing maybe we should be careful about how quickly we're raising this or can we afford this going forward. So, an example recently is Halfords, the retailer who cut their dividend recently. What they did was they held their dividend steady for two years and that's a sign to me that they weren't too comfortable about increasing their dividends each year going forward. 

Cook: So, it's not necessarily a sign that it's definitely going to be cut, but it's something to come and look out for? 

Wenning: Right, that there is some caution internally. 

Cook: Okay. So, what would be number two on your list of things to watch out for? 

Wenning: So, I look out for when a company that has a lot of leverage, specifically companies that are hovering around that investment grade to non-investment grade credit rating, because when you make that jump from investment grade to non-investment grade that can really increase your borrowing costs and it puts a lot more stress on your financials, which therefore stresses the dividend and that happened I think with FirstGroup, the train and bus operator. They had a lot of leverage in their business and they had good intentions of increasing their dividends over the past couple of years, but that just became too much of a burden and eventually it just had to be cut because they had to be able to finance the operations. 

Cook: So, that's something that from the investor's point of view you really need to be looking into the accounts, looking at the numbers for a sign like that? 

Wenning: Exactly. 

Cook: Okay. How about number three then on your list? 

Wenning: I'd say an ultra-high yield is an easy signal for investors to look for, even if you don't know anything about the underlying business. So, my rule of thumb is if a yield is twice the FTSE 100 average or more, that's a concern because the market doesn't give away free yields and with growth. So, the market is saying that there is something probably wrong with the stock. So, be careful when you go into it. Keep in mind that the share price and dividend yield have an inverse relationship. So, ultra-high yield usually indicates that the stock has been on the decline over time, rather than the dividend has being increased faster than the share price. So, it's just a point to be concerned about. 

Cook: So, it could look like a juicy opportunity, but actually on closer reflection it may be something to be wary of? 

Wenning: Right. Especially in markets that are doing very well, you need to be careful of those things. Those opportunities happen, when the market is down and there is a lot of opportunity that the market is panicking, people are force-selling, but when the market is doing well and the yield is still very high, that's a warning sign. 

Cook: Okay. So, those are three great points for investors to look out for. Are there any others that you could kind of add to the list? 

Wenning: Sure. I would say for a company that's made a big acquisition, I think that's a concern. So, a company that goes out and makes a very large acquisition, that's going to stretch their dividend, if they had to borrow a lot of money to do that. The company that I cover, Rexam, did that a few years ago. They bought Owens-Illinois plastics business and they borrowed too much and that was exactly the wrong time and eventually they had to cut the dividend and do a rights issue. So, that is a point to really watch out for. 

Cook: Great, well. Thanks very much for that. I think that's some really useful information for our viewers. 

Wenning: Thanks a lot. 

Cook: For more information on signs of a dividend in danger, see the article below this video. Thanks for watching.


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