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Dividend investing: remember the cash flow

Posted by admin on October 15, 2008 in Investment Information

With news of governments guaranteeing inter-bank lending, the stock markets seemed to have moved from sheer panic to ulcer-inducing worry (if you define that as an improvement). However, some retail level investors seemed to be in full-out panic mode, wanting to liquidate perfectly good long-term assets to minimize short-term damage to their portfolio.

Since many high-dividend yielding stocks tend to be concentrated in the financials, some “dividend investors” are panicking and selling out.

While some of these stocks may never be the same, let us remember one of the fundamental principals of being a dividend investor. Ultimately, you are buying a cash flow from the company; albeit not a guaranteed cash flow but the basis of dividend investing is that you have a bird in the hand- the dividend- above all else, stock appreciation be damn in bad times as long as you have cash in your jeans.

While no one likes it when their stocks go down, as a dividend investor in bad times, the analysis should move away from stock price increase and dividend increases and towards whether the cash flow is defensible going forward. There has been in the blogsphere a lot of mashing of teeth over GE’s decision not to raise its dividend but, as I try to explain below, GE is in pretty dangerous territory from a business perspective to raise the dividend. In fact, doing so many be a penny-wise, pound-foolish move.

How do you tell whether you have invested in a safe cash flow? From a dividend investing perspective, look at the dividend payout ratio. The dividend payout ratio is a percentage determined by the total dividends paid/profits. Thus, a company paying out $1 million in dividends to its shareholders on $5 million in profits has a payout ratio of 20% (I am going to address dividend yield another time). Payout ratios are easy to find now, most financial websites calculate it for you.

For mature companies that have no need to reinvest their profits into expansion (think tobacco and booze), it is not unusual and not dangerous if over 75% of a company’s profits are paid as dividend to investors. After all, what are these companies going to do with all that money? The cash flow one is investing in is stable and predictable.

But for growing companies, as dividend/cash flow investors, it generally becomes dangerous to invest in a company that is paying out more than 50% of its profits in dividends (there are exceptions to the rule). Dividend payout ratios increase for two reasons: (i) a company increases a dividend in a greater percentage than profits are increasing; or (ii) the dividend remains the same but the ratio increases because profits begin to fall.

In the former case, why would a growing company want to give so much money back to a shareholder? Its going to lose its competitive edge that way since its competitors would be reinvesting more of their profits to be market leaders.  A dividend increase in this context is not that desirable for long-term growth prospects (as strange as that sounds).

In the latter case, which is what is happening now, one begins to worry about how safe the cash flow is and whether the company can continue to maintain the dividend payment to you.

Let me use some real life examples.

GE, a long-term dividend paying stock, had a dividend payout ratio in the 40%’s up until earlier this year. It is now 55% according to Yahoo! Finance. For a company that engages in massive R & D, capital expenditures and is positioned in growing industries, you don’t want to be spending that much cash in dividend payments.

As an investor, you would rather have the short-term pain of no dividend increase to allow the company to reposition itself. At this point in the company’s history, an investor should be worried about whether the cash flow can be maintained and not asking for an increase. Although it could be done, it will set the company back long-term.

On the flip side, Johnson and Johnson has been frequently cited as a prudent defensive dividend pick (not a recommendation, please do your own due diligence). Its dividend payout ratio? A much safer 42% according to Yahoo! Finance (a dividend payout ratio in the 35%-45% zone generally strikes a nice balance between paying out an attractive cash flow to investors and ensuring a growing company can reinvest enough profits to continue to expand and increase the dividend long-term).

The morale of the story? In good times, you can have your cake and eat it too: increasing dividends and increasing stock prices. In bad times, one should shift their analysis as to why dividend stocks are so attractive in the first place- it is an investment in cash flows- and determine how safe the dividend is.