It can be tempting to think that because a company has a strong track record of paying and increasing dividends the trend will continue. But this can be a dangerous assumption to make, especially when a company's fundamentals don't appear to support the dividend anymore. A great example of that is what happened with Healthcare Services Group (HCSG -5.36%) in February.
Healthcare Services had a streak of 77 straight dividend increases
Healthcare Services' business centers around housekeeping and dining services it offers to healthcare facilities. It's not a terribly exciting business to invest in, but it has been a stable enough one for the company to be able to afford to pay a high dividend, and continuously increase it for years. Unlike many dividend growth stocks that raise their payouts every year, Healthcare Services had a streak that saw it raise its payouts even more frequently -- every quarter. In October 2022, the company announced a 77th consecutive increase in its payouts.
When I wrote about the stock last year, its streak was at 75, and even then there were signs that the company's financials simply weren't strong enough to continue that payout and keep the streak going for much longer.
The company's payout wasn't sustainable
One look at this chart is all investors should have needed to see that there could have been trouble ahead for the dividend. Without improvement in Healthcare Services' financials, it was really only a matter of time before the company's impressive streak was likely headed for an end.
HCSG Payout Ratio data by YCharts
When the company released its year-end results in February, it announced that it suspended the dividend and that it authorized a share buyback of up to 7.5 million shares, as it was "rebalancing its capital allocation strategy to enhance financial flexibility." But buybacks don't garner as much attention as a dividend -- especially one with a large streak of increases.
Dividend investors should focus on companies with high-profit margins
The problem with Healthcare Services was that the company's margins were never really all that good. In 2021 the company's net income of $45.9 million was only 2.8% of the $1.6 billion in revenue it reported that year. In 2022, the profit margin fell even lower to 2%. By comparison, Johnson & Johnson (JNJ -1.39%), a Dividend King that has been raising its payouts for 60 years in a row, has much better margins:
HCSG Profit Margin (Annual) data by YCharts
When a company doesn't have a strong profit margin, that can make it more vulnerable when sales drop or costs rise, such as amid inflation. Johnson & Johnson's operations are also more resilient, with the company having strong pharmaceutical and medical device businesses that are likely to keep growing in the future. Although it is spinning off its consumer business this year, that could be a better move for the business in the long run, as it will allow it to focus on better growth opportunities.
By focusing on profit margins and payout ratios, investors can make better investment decisions when looking for dividend stocks to hold. In the case of Healthcare Services group, the warning signs were there -- and when in doubt, you're better off going with a safer yield, such as the one from Johnson & Johnson and many other quality dividend stocks.
