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Is there such a thing as a bad dividend increase?

Posted by admin on February 25, 2008 in Investment Strategy

It may be too early to call it but 2008 is quickly becoming the year of the dividend increase. Look at the big names that have increased their dividends this year: Coca-Cola, General Electric, Kimberly-Clark, Abbott. These blue chip companies typically have annual dividend increase so it is not that surprising that the dividend train continues to roll. However, a series of other companies not known for paying or increasing dividends have chosen to become dividend payers; The Encana’s, Roger’s and Tim Hortin’s of the world have jumped into the dividend game by increasing their dividend dramatically. In some cases, the dividend increase is predictable- with the price of oil and gas being what it is, Encana is making too much profit not to put money back into their shareholder’s pocket. In other cases (i.e. Rogers), companies with large amounts of debt on the balance sheet are rising their dividends.

Reading between the lines, with the usual bastion of dividend paying stocks- banks- in such flux, non-traditional dividend payers are using this as an opportunity to attract a pool of investors that typically did not buy its shares.

However, are dividend increase necessarily always a good thing? I previously blogged about dividend yields being over-rated and Financial Jungle made the astute observation in commenting: “Don’t forget, earnings and cashflow aren’t the same thing. A cash poor company can still look profitable on paper. Just because a company has a low payout ratio doesn’t mean the dividend is safe. Not to mention companies fudge their earnings all the time.”

He seemed to hit upon something that others have studied. On Friday, John Heinzl’s from the Globe and Mail wrote about Thomson Financial’s study on dividend yield stocks since 1990 which found the following:

1. Companies with decreasing debt, increasing cash and a dividend payout ratio of under 60% (i.e. 60% or less of its profits are paid in the form of a dividend) and did NOT increase their dividend posted an average annual gain of 7.2%; and
2. Companies with increasing debt, decreasing cash and a raising dividend posted an average annual gain of 5.1%.

On paper this makes sense. If you are increasing a dividend but the amount of available cash is decreasing and debt is going up, a couple of different things are happening: (a) a business is using its money to pay its shareholders in lieu of reinvesting profits for further growth which, over the long term, is going to be problematic (unless the business is mature technologically); or (b) to paraphrase the Thomson Financial researcher, the company is using a rising dividends to distract shareholders from the fact it is not a great cash flow manager and, over the long term, the business is going to hit a wall.

To use a real estate investment analogy, it is like paying yourself more from profits but letting the emergency house repair fund decline and stretching out the amortization period on the mortgage. In the short term, you put more money in your pocket but you don’t have as much cash to put back into the house to sell for greater appreciation.

The study is looking at appreciation of stock and here is where one has to take a contextual analysis. A dividend investor who, contextually speaking, cares for nothing but the fact their dividend is paid (and not slashed) and is not worried about how much the share price is will not pay as much attention to these findings.

However, I am in a stage in my life where I want a little bit of both- a steady dividend and an appreciation in stock price. If you are like me, you want to see the balance between returning money to shareholders in the form of dividends and the business reinvesting profits in growth (which, if done properly, means greater cash on hand which allows greater dividend increases). In this case, I am worried about any business where cash is declining, debt is increasing and dividends are being paid regardless- it shows bad cash management which is particularly important as the economy slows.

Just remember though that increasing cash and decreasing debt is not, in and of itself, an indicator that a stock would go up in price. Look at Johnson and Johnson- its share price has gone sideways the last two years not because of bad management but because of other factors beyond its control (general slump in pharma, its business may be reaching a size and complexity where it is suffering from the dreaded “conglomerate discount”). However, over the long term, these well managed companies should go up in price.

As usual, the devil is in the details so make sure you look at the company’s cash flow from operations and cash on hand as well as the normal dividend indicators such as payout ratio, dividend increases over 5 years and dividend yield.