The first stock I ever owned I didn't even buy -- it was a gift.
My uncle worked for Brown Shoe
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 |
2.5% |
23% |
24% |
|
Genuine Parts |
3.3% |
17% |
52% |
|
Chevron |
3.1% |
10% |
43% |
|
Automatic Data Processing |
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.
