2020 has been a brutal year for dividends. According to asset management company Janus Henderson, global dividends declined by around 22% in the second quarter of the year, and that company expects a 17% to 24% decline across the year. That's a brutal and fast decline driven by the economic slowdown put in place to fight the COVID-19 pandemic, and it represents the worst decline in dividend income since the financial crisis.
Yet in our household, the dividends we've received have held remarkably steady overall and look as if they may actually increase a bit in 2020, bucking the global meltdown. To some extent, we got lucky -- coming into the year, we had no way of knowing just how awful things would be. It wasn't all just luck, however. Our dividend-paying investments have largely been tuned to focus on dividend quality as well as quantity, thanks to learning the painful lessons of the dot-com implosion and the financial crisis.
That focus on dividend quality provides a key driver of how we beat the COVID dividend collapse. While some of our holdings did see their dividends decline, those were offset by both stability and increases elsewhere and by directing our dividend reinvestment into companies that remained strong.
What makes a dividend a quality one?
There are three key characteristics we look for when it comes to determining the quality of a company's dividend: coverage, operational support, and balance sheet quality. While a solid combination of the three does not guarantee a company will maintain or increase its dividend, it does greatly improve the company's ability to do so even when times are tough.
Coverage: Coverage considers a company's dividend compared to the earnings and cash flows it generates. Ideally, we look for dividends to consume somewhere between one-third and two-thirds of a company's cash flow, but we may bend those limits in some cases if the company's structure warrants it.
Believe it or not, if a company's dividend takes up an insignificantly small portion of its cash generating capacity, that can be as almost as worrisome as one taking up too much of its cash. A small dividend is often a sign that either the company doesn't prioritize its dividend or doesn't think its operations can support a more robust one.
On the flip side, a dividend taking up too much of a company's cash flow is a clearer risk. After all, if there's a hiccup in its operations, it may not have the flexibility to both maintain its dividend and handle the hiccup at the same time. In addition, even strong companies need to reinvest in their operations to maintain and grow them over time. If a company's dividend consumes too much of its cash flow, then it will have to rely on issuing stock or taking out debt for even basic expansion plans, and that's dangerous.
Operational support: This process looks at what the company does to earn that cash and how large of an operational moat the company has available to protect that cash flow. It's a more subjective characteristic than the other ones, on this list, but there are still ways to look for it.
For instance, it does not surprise me that both energy pipeline giants that we own shares of, Enbridge (ENB -1.70%) and Kinder Morgan (KMI -2.32%), increased their dividends in 2020 . Once they're built, pipelines tend to be a very low cost way to move energy around, which means energy suppliers will likely cut back elsewhere before they cut back on pipeline use. As a result, both have been able to generate revenue and cash flows despite the general decline in oil usage due to the pandemic.
Further protecting their operational moats is the fact that, while relatively inexpensive to operate, pipelines are very costly and often politically difficult to build. That makes it challenging and slow for new players to enter the market, which helps protect the large and already established players like Enbridge and Kinder Morgan.
Balance sheet quality: This is the process of reviewing how the company manages its assets and liabilities and what it does with the money it earns and retains control of after it pays its dividends. In good times with healthy lending markets, it gets easy for investors to ignore a company's balance sheet or for a company with a stretched balance sheet to look like it can thrive. When financing dries up or lenders get spooked, however, a healthy balance sheet can mean the difference between survival and bankruptcy.
A company's debt-to-equity ratio is an important balance sheet measure that looks at what a company owns compared to what it owes. In most cases, the number should be zero or above, and the lower the number within that range, the healthier its balance sheet. We tend to look for debt to equity ratios between zero and two, though we're occasionally willing to stretch beyond that level if a compelling reason arises.
Another important balance sheet measure is a company's current ratio. That measure looks at its short term assets compared to its short term liabilities. It's a way to see how well it can cover the bills it has coming due within the next year from what it already has on hand or what it can expect to receive from products or services it has already sold. In this case, the higher the number, the healthier the balance sheet, and we generally look for a value at or above 0.5.
Kinder Morgan can also provide a great example of the importance of a quality balance sheet. It was an overly stretched balance sheet -- not operational troubles -- that forced it to cut its dividend in 2015. That it was able to maintain and increase its dividend in 2020 despite the collapse in energy prices during the year is a testament to the great work it has done cleaning up its balance sheet since 2015.
Seek out quality dividends with decent staying power
Dividend stocks can play a powerful role in your overall portfolio. The cash they hand you can be put to any purpose you want -- including reinvesting it in more dividend payers to compound your money that much faster. Still, as the COVID-driven dividend collapse of 2020 reminded us, dividends are not guaranteed payments and can easily be slashed when things go wrong.
As a result, when you're seeking out dividend paying companies to invest in, it's important to look not just at how much income the company offers but also the quality of its dividends. A high quality dividend that sticks around when times get tough just might be worth more to you than a larger one that gets cut as soon as things go even the slightest bit sideways.