How to Avoid a Dividend Cut

High profile dividend cuts from UK banks, BP and more recently Tesco, have impacted income investors. We show you how to look out for key signs your dividends may not be sustainable

Josh Peters, CFA 20 November, 2014 | 11:30AM
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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He's the editor of Morningstar's DividendInvestor newsletter and also our director of equity-income strategy. We're going to talk about how he thinks about risk in the context of a dividend portfolio and also how he thinks about the risk environment in dividends today.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with what risk means to you in the context of dividend payers. How do you think about risk when you're assessing a potential income investment?

Peters: I view risk the same way I view return. It's just on a parallel model. When I think about what I'm going to get out of a stock, I think in terms of is the dividend safe, which gives me the yield that I'm looking at. Will the dividend grow, which translates into dividend growth that should encourage capital appreciation as well as a fatter pay check over time. Then, you take those two factors together, the yield term and the growth term, and that suggests what my total return is.

Thinking about risk, the number one risk that I think about is "What are the odds that this dividend gets cut?" And if you get a dividend cut, you're not going to get the income you expected. And chances are, especially if you get into that situation early, you're going to have a large capital loss as well because it's very difficult to recover from a dividend cut. So, avoiding dividend cuts is the number one factor.

Second, you have the risk that you could own a stock and the dividend growth turns out to be a lot slower than you expect. You typically don't wind up with big capital impairments in these situations, as long as the dividend yield was reasonably high to begin with. But you can end up with a pretty poor total return over a number of years.

Sysco (SYY), the food distribution company, is an example where I bought the stock with a yield around 2%, expected double-digit growth, and watched that growth rate just dwindle and dwindle into the mid- to low single digits. And over the years and years that I owned the stock, before finally letting it go in frustration, I really hadn't made much of a total return beyond the dividend yield itself. So, growth is something to pay attention to.

Then, regarding that third question, "What's the return?" When you think about yield and growth and that combination and what that suggests for your future total returns, you also have to consider valuation very carefully. It's not the biggest threat, I think, just because most high-quality higher-yielding stocks are not prone to be as wildly mispriced as deep cyclicals are or very speculative emerging-growth companies are. But you don't want to pay too much or else your total return is going to suffer even if the dividend is safe and grows as fast as you expect.

Glaser: So, that's how you think about risk on an individual company level. How about when you roll that up into the portfolio? Are there risks there that you're concerned about--correlations, worries that things could impact different stocks in your portfolio at the same time?

Peters: I think that thinking about the macro environment in terms of risk is actually the best way to look at it. Most people on Wall Street say, "Well, how is the economy going to do next year?" And they put together a forecast: Interest rates are going to do X and inflation is going to do Y and GDP is going to grow at Z percent. I really don't like to think in terms of those individual forecasts because, on balance, they're going to be wrong. Instead, I think at the macro level, what are the things that scare me? What are the things that hurt the performance of my portfolio and how do I guard against those? So, what is the risk of a recession and how in turn would a recession, if we had one, affect the dividend-paying capacity of the individual companies that I own?

So, I'm willing to own some cyclicals, for example, General Electric (GE) or Emerson Electric (EMR). But I only want to own those cyclicals that are going to be able to maintain their dividends in a downturn, and it helps to have demonstrated that over time. In Emerson's case, they went ahead and raised the dividend even in 2008 and 2009. GE, I don't think is vulnerable to cutting its dividend in the next downturn just because the makeup of the business has changed so dramatically for the better as the financial-services business has shrunk. But definitely, you don't want to be caught with a dividend cut there.

On the other end of the spectrum, you have to be thinking about inflation and what that could potentially do to the value of your income as well as to the market value of your stocks. I think this is a particular problem when you're looking at regulated utilities. If we were to see inflation move up from the sub-2% type of range where we've been at recently into 4%, 5%, or 6% for an extended period of time, you need to remember that utilities can't just raise prices at will. They're constrained by regulation in terms of how much they can recover from their customers.

So, you might not see utility dividend-growth rates pick up in tandem with an increase in inflation. And that, in turn, means the purchasing power of your income is shrinking. And with inflation, that loops in the threat of higher interest rates as well. But I really like to look at the interest-rate equation as a derivative of inflation versus recession. If you're going to have a major move in interest rates, chances are it's going be in response to one of those two factors. All of the wandering around that interest rates do in the meantime, when people are just worrying about higher inflation or about downside risk to the economy, I think to concentrate on that might miss the point.

Glaser: So, when you look at all of these risks, how does that impact your entire portfolio construction, then? Are you trying to have a good mix of firms that might do better in an inflationary environment and ones that will do better in a recession? Or are you just doing some company-level analysis, and then the portfolio just ends up wherever it might be?

Peters: It's both. On the company-specific level, I need to be comfortable with the safety of every company's dividend. I need to be confident that the dividend is going to grow over the medium to long term, at least--if not every single year, preferably--from every company in the portfolio. And I want that growth to exceed inflation. I don't want my dividend to lose purchasing power even at a very low rate of inflation. So, everybody has to pull their load in the portfolio or there is going to be the opportunity to replace it with something else that will.

But on the macro level, this is where you have the opportunity to diversify and find ways of putting together a portfolio as opposed to just a random collection of stocks where you've got some counterbalancing forces. Earlier, I mentioned that utilities could be more vulnerable in a higher-inflation environment. But if inflation correlates with faster economic growth, then that should be good for some of the more cyclical names. So, those dividends grow faster in that type of environment and offset, perhaps, some of the inflationary pressure on utility dividends.

If there is a recession, then I don't want to be flat-out loaded down with lots and lots of cyclicals. I'm going to want those more defensive businesses. And where you can, it's great to actually find direct hedges. Somebody like a Magellan Midstream Partners (MMP), where you've got a regulatory framework for these refined products, petroleum products pipelines, that's actually indexed directly to inflation. That provides a wonderful hedge. If you own a Magellan Midstream Partners (which not everybody can--it's a partnership and you shouldn't own it in tax-deferred accounts, and not everybody wants to deal with the MLP paperwork), but you can own a Magellan as well as some regulated utilities as well as some triple-net lease REITs, like a Realty Income. And the overall growth characteristics for your income stream of your portfolio should, on balance, respond well to a change in inflation--even if not every company is going to be able to step up its dividend growth in tandem with that.

So, definitely, having diversification, looking at how different types of industries, different types of securities are going to respond to macro changes, that's how you guard against those risks. What you don't want to do is make a flat-out forecast that you need the economy to grow rapidly without inflation or an interest-rate increase in order for your portfolio to do well next year. Some years, it's going to happen; but most years, something is going to be at variance with your expectations. That's certainly been the case here this year.

Glaser: Looking at the environment today, then, do you think investors are being compensated in dividend stocks for the risks they are taking on?

Peters: On a relative basis, I would say yes. When you look at valuations on an absolute basis, then a lot of stocks in high-yield land look kind of expensive--and REITs and utilities are two groups that I would single out, in particular, for that. Interest rates have come down this year on the long end, where a lot of people expected them to go up. And utilities have performed extremely well--so have REITs--relative to the market. Very few people, I think, expected that. I try not even to have those kinds of expectations for a year at a time. So, I'm kind of surprise by everything. But still, it's not what people expected.

But can you continue to hold those stocks? Well, are the dividends safe? Are they going to grow? Can you own them for an extended period of years, where the accumulation of dividends that you've received make up a larger and larger piece of your expected return, as opposed to having to have those stocks go up consistently? From today's levels, you might not have a lot of capital appreciation even over the next couple of years; but you do have the opportunity, with the better stocks in these groups, to have an income stream that's currently better than what you could get from Treasuries and will provide some growth that you can't get from the bond market.

So, on a relative basis, I think choosing dividend-paying stocks is more about your investment goals as opposed to what's popular or what's cheap. On Wall Street at any point in time, I would allow for the possibility that they could become so wildly mispriced, overpriced that you'd have to back out in order to preserve your capital over the long run. But we're not there yet, and I don't think we're likely to get there.

And even if you're uncomfortable with valuations, you still have to think, "Well, what am I going to do with my money? Am I going to replace my high-yield stocks with bonds that are potentially even more vulnerable to a rise in interest rates and aren't going to give me that hedge against inflation that you get from dividend growth? Or am I just going to dart off into other areas of the stock market, become completely agnostic toward income, or try to avoid income because I'm worried about interest rates?" Well, then, you don't have the value of the income anymore, and you may be taking a lot more risk on a fundamental basis than you were before, too.

This is an environment where there are just very few easy choices that are legitimately, absolutely attractive. But on a relative basis, I think dividend-paying stocks--high-quality ones with safe and growing dividends--are still in a position to meet the long-term investment needs, financial needs that most investors have, whether they are leading up to retirement or whether they are already retired and making withdrawals.

Glaser: Thanks for your thoughts on risk today, Josh.

Peters: Thank you, too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

Please note that as this article was originally published on the stock examples given are US companies. However, the concepts are relevant to investors in UK listed equities.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Josh Peters, CFA  is the editor of Morningstar DividendInvestor, a monthly newsletter available in the US, and is author of The Ultimate Dividend Playbook.