Buy Stocks That Pay, And Can Keep Paying

This article was written with Oliver Pursche, the Co-Portfolio Manager of GMG Defense Beta Fund. It was part of a series of articles developed under an agreement with to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site, is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

Dividends are simple, and most often I find they are analyzed at the simplest level, which is the yield, or dividend per share/price per share. Yet by examining dividends just a little more closely, plenty of useful information can be inferred.

Don’t get me wrong, understanding yield is a good thing. However, another equally simple formula–dividend per share/price per share–called the dividend payout ratio offers a trove of information about how safe your dividend is.

The dividend payout ratio is simply the percent of total profits that are paid out to shareholders in the form of dividends to shareholders. The chart here shows the dividend payout ratio for stocks in the S&P 500 (not included are companies that have yet to pay a dividend).

Note the companies at the top, including Sealed Air (SEE), Harrris Corp. (HRS) and PerkinElmer (PKI), where the dividend payout ratio is greater than 100%. This means the annual dividend exceeds the annual earnings per share. If you own stocks where the payout ratio is greater than 100%, you should be concerned. Not alarmed necessarily, just concerned enough to look at their financials a little more closely.

There might be a good reason for a payout ratio above 100%. For instance, there could be significant seasonality in a company’s earnings, and the last four sequential quarters that make up the current earnings per share could be lower than the annual earnings, which handily cover the dividend.

A company might have suffered a one time cash or non cash hit to earnings. Or there can be significant depreciation in a company’s assets–a non cash expense–that creates a significant deviance between earnings per share and cash flow per share.

Of course it could also be the company is simply doing poorly, and the dividend is about to be significantly cut, or dropped altogether. That’s why you examine stocks with very high dividend payout ratios carefully.

Note also the stocks at the bottom, including Hartford Financial (HIG), Best Buy (BBY) and Kinder Morgan (KMI), where the earnings per share are negative, but the companies continue to pay a dividend. Obviously, this is not a sustainable trend. However, additional analysis may reveal the hit to earnings was a one time event, or maybe even an accounting irregularity. As with stocks where the payout ratio is greater than 100%, you don’t want to sit passively on these shares.

The dividends for stocks that have dividend payout ratios between 60% and 100% are, comparatively, much safer. However, they still carry risks. For instance, if revenues soften, or expenses increase (or heaven forbid both happen at the same time), earnings are going to deteriorate. Under these circumstances, the only way a company can maintain its current dividend is to raise the payout ratio.

For companies with already high payout ratios, this can be problematic, as a higher percentage of earnings paid to shareholders may crimp capital expenditures or research and development commitments that are needed to keep the business growing. Mortgaging the future to pay shareholders today likely isn’t going to do much for the performance of the shares. Neither, by the way, is cutting the dividend. And that’s precisely the risk shareholders can face with companies that pay a large percentage of their earnings in the form of dividends.

This risk notwithstanding, we own shares in Southern Co (SO) and DTE Energy (DTE). In particular, we have looked at and avoided shares in Exelon (EXC) and CMS Energy (CMS).

Stocks with payout ratios of between 25% and 60% are attractive in terms of maintaining or increasing their dividends, for all the reasons that companies with payout ratios of between 60% and 100% are not. That is, a temporary dip in earnings is unlikely to result in a change in the dividend, or cause management to make the difficult choice to payout earnings that should be allocated to growing the business, both of which would put downward pressure on the price of the stock.

Although there are plenty of companies to like in this category, we are particularly fond of and own Sysco Corp. (SYY), Darden Restaurants (DRI), Kellogg (K), and McDonald’s (MCD). All of these companies pay a dividend north of 3% and with payout ratios between 50% and 58% offer protection from a dividend cut on the downside, coupled with some room to increase the payout ratio for some upside.

Finally, companies with dividend payout ratios of less than 25% are candidates to become dividend aristocrats. Here we look for companies that are mature, but nonetheless have lots cash-flow. Without a mandate to reinvest a significant portion of the profits back into the business, these are companies that may continuously and consistently raise their dividends. Over the long term, these increases can have a powerful and substantial impact shareholder returns.

In this category, we like and own Apple (APPL), IBM (IBM), CVS Caremark (CVS) and Tenet Healthcare (THC). We have avoided Citigroup (C) and Capital One (COF).

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