Why This Dividend Stock Broke My Heart, and How You Can Avoid My Misery

The first stock I ever owned I didn't even buy -- it was a gift.

My uncle worked for Brown Shoe (NYSE: BWS  ) in the 1980s. I was a kid back then, and knew little about the market, but he purchased about 20 shares of his employer for me and my sister and cousins.

I did know that the Brown Shoe dividend checks I got in the mail every quarter were incredible. As a kid in school, I needed money to buy junk food, Birch beer, baseball cards, and arcade games. I made money by doing the stuff kids do to make money: delivering newspapers, raking leaves, stacking wood. They were labor-intensive and didn't pay all that well. By contrast, those dividend checks were effortless.

Brown Shoe would go on to break my young heart -- but not before teaching me a good lesson about dividends.

Let me explain
On the face of it, the company looks like a dividend overachiever. Brown Shoe has paid 353 consecutive quarterly dividends -- that's 88 straight years of returning cash to shareholders. Over the past five years, it has grown its dividend by an annualized 9.5%.

In the late 1980s, when I was given shares, Brown Shoe was paying a quarterly dividend of $0.40. Here's the quick math on my stake (Note: These numbers are approximate because I don't have the actual late-'80s paperwork):

  • 20 shares paying $0.40 = $8.00 a quarter, $32 a year
  • $32 a year back then = $54 today, adjusted for inflation

A lesson in income investing
That's not the kind of money anyone could subsist on, but during high school and then college, I counted on those checks to help pay for gas and food (and by food I mean beer). But one day in the mid-'90s, the check arrived and, without warning, it was smaller. A lot smaller.

I wasn't keeping tabs on the stock back then, but in the third quarter of 1995, Brown Shoe announced a 37.5% dividend reduction. The company didn't hide the reasons:

The dividend had been increased or maintained for 20 years, and over the years had contributed very substantially to shareholder returns. But in recent years the dividend has principally been supported by cash flow from structural change -- business sale or liquidation and plant closings. The conclusion of these structural changes, difficult retail business and pressure on operating earnings in 1995 which was expected to continue into 1996, and the continuing high priority of protecting the balance sheet and our capability to finance the operation of the company, collectively made necessary the lower dividend. [emphasis mine]

Some two years later in 1997, the Brown Shoe board reduced the dividend again, from $0.25 all the way down to $0.10. By then, I was left with two bucks a quarter:

  • 20 shares paying $0.10 = $2.00 a quarter, $8 a year (down from $32 a year)

Over the course of two years, my dividends were 75% lighter, and I had absolutely no idea it was coming.

I want my two dollars
Perhaps heartbreak and misery overstate the matter, but I really was bummed when this glorious, passive stream of income suddenly dried up.

Brown Shoe cut its payout because "in recent years the dividend has principally been supported by cash flow from structural change." As I became a student of investing, I embraced the simple lesson that dividend cut taught me: Focus on the free cash flow payout ratio.

The regular payout ratio -- dividing dividends per share by earnings per share to arrive at the percentage of a stock's earnings paid out to shareholders -- is a fair way to gauge the health of dividend payments. In the year ended 1993, Brown Shoe's payout ratio was 594%. Ouch.

Even still, earnings do not equal cash. A healthy, growing dividend stock will pay future dividends because its core business is throwing off plenty of cash. In the two years before Brown Shoe cut its dividend for the first time, the company had negative free cash flow. The same was true in 1996 and 1997, just before the second cut came. If it was to continue paying a good dividend, the company would have to borrow money or sell assets, neither solution sustainable.

How about some current ideas?
The FCF payout ratio, then, is as simple as it sounds: Divide dividends per share by free cash flow per share. (Here's a primer on FCF.) A good rule of thumb is to look for stocks with an FCF payout ratio below 80%, and in the tradition of my colleague Ilan Moscovitz, simultaneously screen for companies with manageable debt loads.

Earlier this year, I shared the 10-10 test, an interesting way of searching for stocks with growing dividends. Today, I'm going to present a new screen that I hope will help you avoid some of the misery associated with a dividend cut.

The following four stocks each have a yield higher than the market average. Their dividends are in the safe zone, according to their FCF payout ratios. And they have manageable debt loads, as measured by the debt/equity ratio.

Company

Dividend Yield

Debt-to-Equity Ratio

FCF Payout Ratio

General Dynamics (NYSE: GD  )

2.5%

23%

24%

Genuine Parts (NYSE: GPC  )

3.3%

17%

52%

Chevron (NYSE: CVX  )

3.1%

10%

43%

Automatic Data Processing (Nasdaq: ADP  )

2.7%

1%

47%

Source: Capital IQ, a division of Standard & Poor's.

These dividends are safe -- the opposite of the mid-1990s Brown Shoe payout. The above isn't a "go buy now" list, as I've given only one piece of the puzzle. They're a good place to start, though.

Wrapping up
I sold my Brown Shoe shares in the late 1990s, but the stock taught me two enduring lessons: the need to watch the payout ratio in general and the FCF payout ratio in particular, every quarter; and when screening for prospective dividend stocks, look at the three- or five-year payout ratio record.

If you want a short list of prospective dividend stocks, I recommend our popular research report, 13 High-Yielding Stocks to Buy Today. To claim a free copy, just click here.

Fool.com managing editor Brian Richards doesn't own shares the companies mentioned. The Fool owns shares of General Dynamics. Motley Fool newsletter services have recommended Automatic Data Processing and Chevron. The Fool has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (84)

Comments from our Foolish Readers

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 May 13, 2011, at 7:07 PM, naivenerd wrote:

    I had the exact experience with GE which cut its dividend after the current President said they would continue their payout at least through the remainder of that year. What a disappointment to hear one thing from the President and then see them do the exact opposite. My lesson: You can't trust the President of GE.

  • Report this Comment On May 14, 2011, at 5:03 AM, dbtheonly wrote:

    'Nerd,

    There is a simple solution.

    Sell your GE stock.

  • Report this Comment On May 14, 2011, at 8:16 AM, StarWitchDoctor wrote:

    Yes, finally i got a great article from the mf for free without a bunch of selling hooplah.

  • Report this Comment On May 15, 2011, at 12:12 AM, somethingnew wrote:

    This was very informative. Thank you.

  • Report this Comment On May 16, 2011, at 8:24 AM, JCashForever wrote:

    Not to rain on the parade, but it seems the author's misery from BWS was somewhat self-inflicted.

    What he doesn't mention is that he sold his BWS stock in the $5 to $10/share range in the late 1990's, and the stock shot up to $36/share less than ten years later! All the while, it still paid a dividend.

    If we do the math, let's say he sold his 20 shares at $7.50 a share. His take would be $150. If he would have held the stock and sold at 2007, he would have had a $36/share stock and could have sold it all for $720...plus collecting divvys all the way.

    The real lesson here is not an evaluation of free cash flow. The lesson is that companies with long histories of paying dividends tend to continue to pay dividends. Even during the hard times of the late 1990s, BWS continued to pay a dividend to its loyal shareholders. That's something that you cannot discount lightly. And so, the author would have benefited handsomely if he had held his shares. For he would had the income from the continuous divvys and the 5-fold capital gain in the stock price. That's called "making money."

    Of course that bit of advice doesn't fit into a neat easy-to-calculate formula like FCF. But I've not seen a formula yet that makes a gain of $150 bigger than $720 (plus divvys).

  • Report this Comment On May 16, 2011, at 10:28 AM, TMFBrich wrote:

    @JCash,

    <<What he doesn't mention is that he sold his BWS stock in the $5 to $10/share range in the late 1990's, and the stock shot up to $36/share less than ten years later!>>

    Well, ok, but you're being awfully selective about the sell date. It's true that if I had held my stake and sold at BWS's all-time peak, I would've made out.

    Take a look at this chart: http://bit.ly/lBO2IW. It shows the 23-year stock chart for BWS, from when I acquired my stake in the late 1980s through today. Total return over that time? A loss of about 20%. Selling in 2006 and 2007 would've netted a nice gain. Not true for any other year.

    <<The real lesson here is not an evaluation of free cash flow. The lesson is that companies with long histories of paying dividends tend to continue to pay dividends.>>

    In a prior article, I quoted NYU professor Aswath Damodaran, who said that "dividends are like getting married; buybacks are like hooking up." I love companies that consistently raise dividends. But as this chart shows, be wary of those who have to cut their payouts: http://2.bp.blogspot.com/-Gt0MBpqzsUE/TYFegwDzKHI/AAAAAAAACx....

    From 1972 to the end of 2010, Ned Davis Research found that S&P 500 companies that initiated or raised their dividend turned $100 into $3,545. Those that cut or eliminated their dividend turned $100 into ... $82 -- the worst returns of the bunch.

    -Brian Richards

  • Report this Comment On May 17, 2011, at 3:08 PM, Gerphligit wrote:

    In your table, the dept and FCF ratios for GPC and CVX seem to be reversed. As for ADP, all the sites I have check say the dept ratio is 1% - curious.

    Thanks, otherwise, for a thought provoking column.

  • Report this Comment On May 18, 2011, at 4:20 PM, TMFBrich wrote:

    @Gerphligit,

    You're right -- I had those transposed. The table has been corrected. Thanks for reading, and for pointing out the error!

    Best regards,

    Brian Richards

  • Report this Comment On May 20, 2011, at 12:04 PM, karakoram wrote:

    So what's the skinny on American Capital Agency (AGNC)?

  • Report this Comment On May 20, 2011, at 1:00 PM, TMFBrich wrote:

    @karakoram,

    I haven't looked at AGNC, but here's a piece on the mortgage REIT sector from my colleague Jim Royal: http://www.fool.com/investing/general/2011/04/13/the-markets....

    Best regards,

    Brian Richards

  • Report this Comment On May 20, 2011, at 1:20 PM, kdsimms wrote:

    FINALLY... an article that doesn't span 15-20 webpages and not chocked full of stuff MF is trying to sell to me.

    In some prior articles (sent out by email) I have done some research on. It turns out the "Hot advice" MF proclaims has been info out on the street for months.

    So I question what they are trying to sell to us these days. Hmmm...

  • Report this Comment On May 20, 2011, at 1:31 PM, TMFHelical wrote:

    I want my $2.

    LOL

  • Report this Comment On May 20, 2011, at 2:46 PM, PhotoPhool wrote:

    Your Uncle was wonderful. What a great gift to give the children - stocks to give the kids some cash and their first insights into how shareholding works.

    That wasn't the point of the article. However, it seems like a much better idea than enclosing a big check in their birthday cards.

  • Report this Comment On May 21, 2011, at 7:12 AM, RedRiverII wrote:

    Thanks for the article. I too, spent a lot of money on food, ( read beer ) in college. LOL I think I'll buy my niece and nephew a stock instead of talking their ears off about the value of saving and investing. It seems your Uncle taught you a great lesson. Thanks Brian's Uncle.

  • Report this Comment On May 22, 2011, at 7:49 PM, blesto wrote:

    Cool article and a good lesson on FCF!

    Have you ever tried to calculate what you would've had if you were able to reinvest those dividends instead of spending it?

    I suspect the number of shares would be substantial and if you held til that peak in '06 - '07 ...

    Well, that should've been a pretty penny.

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