The payout ratio serves as a crucial indicator, yet it isn’t the only metric for evaluating a dividend’s security. Relying exclusively on this ratio may lead to unforeseen shocks. At DSR, we’ve developed multiple tested strategies to help avoid most dividend cuts. These have been validated across diverse market environments.
These strategies have primarily enabled us to evade significant dividend challenges. Consistently employing them will substantially reduce your risk of retaining shares in companies that might lower their dividends.
Think of this as an evaluation of your portfolio. The summer season presents a perfect chance to unwind by the pool and fine-tune your investments before the onset of fall market fluctuations.
1. Trust the Market: Exercise Caution with High Dividend Yield Stocks
A significant warning sign is often apparent: the stock chart. If numerous investors are unloading shares, causing the stock price to decline and the yield to rise, there’s likely a rationale behind it.
In the world of finance, nothing comes without a cost. A thriving business doesn’t find itself in trouble without a reason. When facing an unusually high yield, it’s crucial to investigate the underlying cause.
This doesn’t imply you should hastily sell high-yield stocks; rather, it advises a thorough examination.
A high yield acts as a red flag. In isolation, it offers little insight—it could be a fleeting market reaction or the onset of a downtrend. If you cannot ascertain why the yield is elevated, you might be overlooking critical risks.
What constitutes a high yield for me? I often express a preference for low-yield, high-growth stocks over high-yield, low-growth counterparts. For me, a “high yield” begins around 5%.
During market downturns, many solid companies may present yields exceeding 5%, creating excellent buying opportunities. However, under typical circumstances, such yields frequently indicate elevated risk or weak growth outlooks.
When a stock like Telus (T.TO / TU) exceeds a 5% yield, I take notice. I don’t automatically dispose of it, but I delve deeper.
If you hold high-yield stocks, utilize this checklist:
– Has the company raised its dividend in the past five years?
– Is dividend growth steady or decelerating?
– Are payout ratios sustainable or exceeding 100%?
– What is the trajectory of those payout ratios?
– Is there a transparent reason for the elevated payout ratio?
– Is the company flourishing or facing challenges?
– What are the trends in EPS and cash flow?
Negative responses may signal potential challenges ahead.
2. Avoid Stocks Lacking Dividend Growth
Even slight inflation rates can diminish purchasing power over time.
For example: By 2046, at age 65, I would require $118,500 annually to match today’s $75,000, considering 2.1% yearly inflation. By age 80, that amount escalates to $161,800.
Without an increase in dividend income, your lifestyle could suffer. A lack of dividend growth often points to more profound issues.
Companies sustaining unchanged payouts during prosperous periods risk having to reduce them in downturns. Companies showcasing revenue and profit growth but failing to increase dividends in recent years are unusual. Typically, stagnation indicates challenges.
A cautionary example: H&R REIT
H&R reduced dividends during the COVID pandemic and in 2009—two cuts within a decade. Despite appearing stable, its business framework couldn’t support continuous growth.
H&R serves as an example of a “promising façade” company—thriving during favorable conditions but struggling otherwise. Its dividend history illustrates this.
Examine your portfolio for firms that haven’t consistently boosted payouts over the past five years. There may be an underlying issue.
“But Mike, avoiding dividend increases in tough times reflects good management.”
My reply:
“Poor management leads to a difficult future. If a company is unable to sustain a higher dividend today, it has made inadequate choices in the preceding five years.”
Validate this assertion with the CEOs of Intel (INTC), Walgreens (WBA), or BCE (BCE.TO).
Hoping for the best isn’t a strategy. If a company fails to boost its dividend during prosperous times, what might occur during a downturn? You can likely predict the outcome.
In the video below, I outline three strategies to evade dividend reductions and discuss how to sell with confidence before it’s too late.
3. Watch for a Weak Dividend Triangle
As I’ve noted, the Dividend Triangle is a potent instrument for evaluating dividend safety. It comprises three components:
Revenue growth – A business must experience increasing sales. Companies with various growth avenues can enhance sales each year, encountering recessions from a position of strength.
Earnings growth – Dividends are reliant on profits. While GAAP EPS isn’t flawless, I focus on adjusted EPS and free cash flow trends across several years. A consistent upswing is desirable.
Dividend growth – This reflects management’s confidence. Increased dividends indicate that the company can expand, reinvest, and reward shareholders.
Stagnant revenue serves as the initial warning. Flat or decreasing EPS over multiple years is another red flag. Without growth in both areas, sustainable dividend growth is improbable.
Why the Triangle is Effective
Companies that lose market share or lack competitive advantages eventually reveal vulnerabilities in the Dividend Triangle. The appeal of