Can You Count on Your Dividends?

Got dividends?

Probably not as much as you previously thought.

The Associated Press recently reported that dividends "are being cut at the fastest pace in at least 50 years." What's more, the cutters aren't just dividend upstarts like Whole Foods, which only began paying a dividend in 2004. No, we're talking blue-chip dividend stalwarts -- like Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) -- both of which have reduced their quarterly dividend to $0.01 as part of their bailout terms. Others, like Pfizer (NYSE: PFE  ) and Dow Chemical (NYSE: DOW  ) , have drastically cut their hefty yields to fund pricey acquisitions. Just yesterday, General Electric (NYSE: GE  ) announced a 68% dividend cut to help preserve its balance sheet and AAA credit rating.

It's not easy being a dividend
All told, as my Foolish colleague Ilan Moscovitz writes, a mind-boggling $22 billion in dividend payments were eliminated during this past quarter alone. This is especially distressing because it's estimated that more than half of America's retirees rely on dividend income to maintain their standard of living.

Was there any way investors could see this coming?

Perhaps.

Not every dividend cut mentioned above was expected, but many companies gave signs -- or are giving signs -- that a savvy investor could have noticed.

High expectations
It's important to remember that while the market is often irrational, it isn't always.

As such, a high yield is often indicative of underlying troubles because it indicates that shares have been beaten down to such an extent that investors have serious doubts about the firm's financial position. The company might go under, or, more likely, it could cut its dividend, thereby reducing the yield you thought you paid for. One could argue that this is the case at Allied Capital (NYSE: ALD  ) , which currently yields a whopping 77.2%.

Bottom line: Investments in stocks with yields over 20% are better left to speculators.

High payouts
But even low-yielding companies can face a dividend cut. Perhaps the best way to assess both the near-term and long-term feasibility of a company's dividend is by determining the company's dividend payout to free cash flow ratio. This metric pits a company's annual dividend outflows against its annual free cash, i.e. the uncommitted cash a company is left with after maintaining its current business and investing in future business.

Companies have a very difficult time supporting free-cash-flow payout ratios above 100% because the only way to pay out more cash than they earn is to issue shares, issue debt, sell off assets, or deplete cash reserves -- none of which are sustainable over the long term.

By way of example, here are three such companies whose dividends might soon either go the way of the dodo or Grant Williams as evidenced by this ratio:

Company

Market Cap

Dividend Yield

Free-Cash-Flow Payout Ratio

China Mobile (NYSE: CHL  )

$174 billion

3.9%

2,501%

Luxottica

$4.7 billion

4.6%

633%

Boston Properties

$4.5 billion

7.3%

538%

Data from Capital IQ, a division of Standard & Poor's.

China Mobile has done an excellent job growing its business, but all that growth costs money, and last year's whopping $24 billion capital expenditure budget will make it very difficult for the company to continue to afford paying out $5 billion a year in dividends. Luxottica's dividend is paid out as a percentage of earnings, but the company has upcoming debt obligations, so it may make the choice to pay out a smaller amount in the future. Boston Properties, like many other heavily indebted REITs, faces a double-whammy in the form of tight credit and a brutal commercial real estate market; the architecture billing index, a leading indicator of commercial construction spending, sits at an all-time low.

Dividend defense
Though I in no way mean to argue a forsaking of dividends altogether (in fact, I think now is an opportune time to pick up solid dividend-paying companies), it is extremely important to be on the defensive against companies that are spending more dividends than is feasible given our economy's current environment. The stakes have changed.

This is exactly the tactic the team at Motley Fool Income Investor, led by former hedge fund analyst James Early, is employing in the current environment so hostile to dividends. They are assessing the strength and sustainability of the market's top dividend-paying companies. You can see their top recommendations completely free for the next 30 days. Click here for more information.

Fool analyst Adam J. Wiederman owns shares of General Electric, but of no other company mentioned above. Pfizer is a former Income Investor recommendation and Fool holding, as well as a current Inside Value selection. Luxottica is a Global Gains pick. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 06, 2009, at 12:52 AM, cautiouswillie wrote:

    Yes, you CAN count on your dividends... if your stock is preferred. Notice the only stock WEB is buying these days is preferred? With moderate risk (and don't almost all companies qualify these days) there are yields between 15% and 20% to be had... a plethora of them, in fact. (The risky ones trade at 50%-100% yields.)

    Oh, and by the way, the stock price itself has potential to go back up 40% - 100% to their normal trading ranges when sanity returns to the markets. That on top of the 20% per year while we wait. While the markets rage and churn, just sit back and collect returns matching the Oracle's.

    Too bad these don't show up on stock screens. I bought some LHO-G prefs for a yield of over 20%. Low risk - high coverage (safety factor). Nice thing: even if they skip a dividend, they still owe it, and they can't pay any common dividend till the prefs get theirs.

    Why even mess with common dividends these days?

  • Report this Comment On March 06, 2009, at 7:42 PM, plouf wrote:

    Yes, you CAN count on your dividends... if your stock is preferred. Notice the only stock WEB is buying these days is preferred? With moderate risk (and don't almost all companies qualify these days) there are yields between 15% and 20% to be had... a plethora of them, in fact.

    Can you give some examples of stocks with 15-20% yields?? Thanks -

  • Report this Comment On March 06, 2009, at 8:57 PM, cautiouswillie wrote:

    Preferred stocks list:

    Over 15%:

    HST-E Safe as a house, lowest return

    Over 20%, still safe:

    EPR-x (x being any of their series: B C D or E)

    LHO-x (B D E or G)

    SHO-A

    There's some to get you started. Those are the ones not as risky as others with over 50% yields. Most ar ein hotels, because that's where I discovered them. I just haven't made the time to find more.

    Here's one I trust enough to buy (not too much, but just some to add some spice to my portfolio): FCH-C (return of over 60%). I happen to know the company and believe they' have what it takes to get through, but that's just an opinion.

    Do some homework, there are many more. Not easy to find, because stock screeners don't show them up, but they're out there.

    Here's how I found them: On Google Finance, begin with one of the above, but use the common stock ticker. They list competitors below. Then type in the competitor ticker and put a dash behind (e.g. EPR-) and wait. Google will bring up all the pref shares for that ticker. Not as easy as a stock screener, but infinitely more rewarding.

    Note: this condition won't last. Look at the price histories of all these prefs. They all used to trade forever in a narrow range: $24-26. The forced liquidations of ETFs, mutual funds and hedge funds have deluged the market with stocks the average investor doesn't know of or doesn't want (probably because they were so boring in the past). I'm not sure, that's just a guess. All I know is these conditions haven't existed in like forever and they will not be there when the market regains its balance.

    Good luck!

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