In today's low interest rate environment, investors looking for income from their portfolios are increasingly turning to dividend-paying stocks. The challenge with that approach is that dividends are not guaranteed payments. As 2020 showed us, when companies run into serious trouble, they'll cut their dividends to protect their overall operations.
As a result, if you'd like to find the best dividend stocks, you'll have to look well beyond just the company's yield. You'll want to look for a healthy balance sheet, solid dividend coverage, and a reasonable operational moat to get a feel for how that dividend is supported and why it may be sustainable over time. A well-supported dividend still isn't a guarantee of success, but it certainly can help tilt the odds in your favor.
Why balance sheets matter
In good times, it gets easy to overlook a company's balance sheet. In fact, when borrowing is easy and markets are optimistic, a healthy balance sheet can even look like an anchor preventing the company from growing at its maximum potential. When times turn tough, however, the value of a strong balance sheet quickly becomes apparent. After all, as Warren Buffett famously said, "Only when the tide goes out do you discover who has been swimming naked."
When the lending market tightens and markets become pessimistic, companies that need to borrow money are the first to run into trouble. When things get bad enough, it may not even matter whether the company needs to borrow that money to cover its operating costs or simply to roll over its existing debts. If a company needs to borrow money and can't, that forces the business into default and potentially bankruptcy, which could wipe out its shareholders entirely.
With that background, it becomes clear why companies will cut their dividends when the going gets tough. If the alternative is a complete wipeout of the shareholders, suspending or reducing the company's dividend while surviving to operate another day is a much less ugly outcome.
A company's debt-to-equity ratio is key to understanding its balance sheet's strength. That measure looks at how much a company owes compared to what it owns. Think of it this way: If you have a $150,000 mortgage on a house valued at $200,000, you have $50,000 of equity and a 3:1 debt-to-equity ratio on that house. The lower that debt to equity ratio is (as long as it's zero or above), the healthier the company's balance sheet.
Another key balance sheet measure is current ratio. That looks at a business' short-term assets compared with its short-term liabilities. It showcases how prepared the company is to pay the bills it has coming due within the next year based on what it already has available to it. The higher that measure, the healthier the company's balance sheet, and the better its ability to manage through a period when the lending market suddenly dries up.
Why dividend coverage matters
A company's dividend can only be sustainable if it gets paid out of money it generates from its ongoing operations. It's also important to note that once money is paid out in dividends, it cannot be used for any other purpose by the company. A dividend payment can't be used to shore up its balance sheet, maintain its equipment, or invest in expanding its operations -- all of which may be important to any company's long-term prospects.
Clearly, a company can't pay out too much of what it earns and still organically sustain itself and its growth. On the flip side, a dividend that doesn't consume all that much of a company's cash flow can also be problematic. This is because it could be a sign that either the company's management doesn't value its dividend or it doesn't believe its operations are secure enough to sustain a larger payout. Either of those possibilities could mean that the dividend is at risk when times get tough.
That makes a "Goldilocks" dividend coverage level something investors should look for when considering a dividend-paying stock. A payout somewhere in the range of one-third to two-thirds of earnings or cash flows is a decent target, although that range can be extended a bit to between one-quarter and three-quarters if needed.
Note that some investments pay out higher dividends because their structures mandate it. Real estate investment trusts, for instance, must pay out at least 90% of their earnings as dividends. In addition, partnerships are pass-through entities where the owners -- not the business -- pay the tax on the partnership's earnings. That incentivizes partnerships to pass through a lot of those earnings in the form of dividends so their owners have the cash to pay those taxes.
While those structurally high payments assure high yields when times are good, they still suffer from the reality that money paid out as dividends can't be used by the company to shore itself up. That leaves REITs and partnerships potentially exposed when times get tough and funding or revenue dries up.
Why operational moats matter
Most companies operate in competitive environments, with other companies vying to address the same customers' needs with similar offerings. Even so-called "natural monopolies" like telecom and energy providers face competition today. The beauty of a competitive environment is that it helps keep prices more in check. The challenge it brings is that the more competitive an industry is, the more of their cash flows companies in that industry generally have to reinvest in their operations to remain competitive.
Since dividends can only be sustainably paid from operating cash flows, the more of their cash they need to put into their business just to remain competitive, the less they have available for dividends. In addition, the more they spend on those dividends, the more risk they expose themselves to from their competition being able to invest more in growing their share of the market.
Unlike balance sheet strength and dividend payout levels, operational moats are a bit harder to measure with basic equations and ratios. A reasonable way to look for one, though, is to try to figure out how the company makes its money and ask yourself how a competitor would try to get in on that action. The tougher it would be to take on its business, the stronger its operational moat probably is. The stronger its operational moat, the better the likelihood that its dividend will be maintained.
Great dividend companies are out there
Even in today's world where the one-two punch of the COVID-19 pandemic and low interest rates makes it hard to find solid income-generating investments, great dividend stocks are out there. You have to make sure you're looking beyond a company's headline payment and yield information and into the drivers that help those dividends last. By digging into those drivers and looking for companies that look capable of maintaining their dividends even when times are tough, you just might find the portfolio income you're looking for.