Updated: November 2, 2016
Dividend cuts hurt your portfolio in lost income and likely great unrealized capital losses. There are ways to lower the chance of dividend cuts — by looking for companies that pay safe dividends. Here’s how you can go about doing it.
Does a low payout ratio suggest faster dividend growth?
The payout ratio is the amount of earnings paid out in dividends to shareholders. Just because a company has a low payout ratio does not imply that it will continue growing its dividends.
Businesses in stable industries tend to have higher payout ratios. For example, it is normal for industries like consumer staples, tobacco, and utilities to have relatively higher payout ratios of 60-70%. Examples include Coca-cola (NYSE:KO), Philip Morris (NYSE:PM), and Wisconsin Energy Corporation (NYSE:WEC).
On the other hand, if a company has higher earnings variability (bumpy earnings), it will need a higher cushion for its dividend in preparation for periods when the company’s profitability is challenged.
In other words, such a company will have a lower payout ratio. Thus, the payout ratio is just one of the metrics which helps determine if the dividend is safe and has potential to grow.
A good way to tell if a company is meant to have a low payout ratio or not is to compare its payout ratio to its peers’ payout ratios.
Since they’re in the same industry, they’d have a similar amount of cushion for their dividends.
For instance, Ross Stores (NASDAQ:ROST) and TJX Companies (NYSE:TJX) are both in the cyclical business of apparel retails.
Ross has a payout ratio of 19%, while TJX’s is 25%. If both companies decide to keep their payout ratios where they are, the only way the apparel retailers can grow their dividends is to rely on earnings growth.
So, estimating the earnings growth of a company becomes a good exercise to help determine the safety of a company’s dividend and its growth potential.
I’d argue that in the medium term, Ross has the ability to grow its dividend per share at a faster rate than TJX because the former has a lower payout ratio and is expected to grow its earnings per share at a faster rate.
Of course, a company can choose to grow its dividend at a faster rate than its earnings growth. In this respect, other than with the “help” of earnings growth, the company must raise its payout ratio.
Amgen, Inc. (NASDAQ:AMGN) is one example. Its dividend is 26.5% higher than a year ago, but its earnings growth was “only” 19% in 2015.
How to increase the likelihood of dividend growth
Does the company have economic moats?
Companies with economic moats have one or more competitive advantages over peers. The wider an economic moat a company has, the higher likelihood it can protect its dividends over long periods of time.
Matthew Coffina, from Morningstar, talks about Building a Moat in your Portfolio (pdf link to his slides) from March’s Individual Investor Conference. He lists the 5 sources of a moat:
- Network Effect – the value of a company’s service increases as more people use it
- Intangible Assets – patents, brands or regulatory licenses which protect excess returns
- Cost Advantage – economies of scale, access to a unique asset
- Switching Costs – it’s too expensive for customers to stop using a product
- Efficient Scale – a niche market is effectively served by one or a small handful of firms
A company with a wide moat has multiple competitive advantages over its competitors. For example, I think that Coca-Cola’s moat comes from its intangible assets, cost advantage, and possibly efficient scale, as Coca-Cola is a world-renowned brand, and sells its products in more than 200 countries through its distribution system, and the only other big player is Pepsi (NYSE:PEP).
As Mr. Coffina shows in his slide, wide moats matter because wide moat firms are “growing earnings faster” and have “higher free cash flow.” Further, wide moat businesses are able to “sustain excess returns longer than firms without moats.” As a result, I’d like to add that wide moat companies’ dividends are safer and have a higher chance of continuing to grow.
Does the company have a strong balance sheet?
A company that you expect a safe dividend from should not be excessively burdened with debt, especially long-term debt. My way of checking if a company has excessive debt, again, is to compare it to its peers.
For instance, the Big 3 Canadian telecoms, BCE (TSX:BCE), Telus (TSX:T) and Rogers Communications (TSX:RCI.B) have debt/cap ratios of 42%, 52% ,and 66%, respectively. As a result, investors should feel least comfortable holding Rogers.
It helps me to sleep well at night to hold companies with solid credit ratings. Here are the Morningstar credit ratings of some companies mentioned in this article:
|Ticker||S&P Credit Rating|
Here’s a high level view on what the credit ratings mean:
Learn more about Morningstar’s Corporate Credit Rating system.
If dividends are important to you (whether in the present or future), then, a review of all these areas: payout ratio, economic moat, debt levels, and credit ratings on all your holdings and potential buy candidates will help you build a portfolio, which generates a safer and growing dividend as a whole.
The original version of this article first appeared on Seeking Alpha: Build a Margin of Safety for your Dividend Income
- A low payout ratio does not suggest lots of room for dividend growth.
- Companies with wide economic moats are more likely to continue growing their dividends.
- Companies with strong balance sheet strength are more likely to continue growing their dividends.
Morningstar video on Where to Find Margin of Safety
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Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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