When GE announced last Monday it was cutting its dividend in half, investors were reminded that the search for yield is complicated and more risky than they might have believed.
Before the dividend cut, GE was paying out 24 cents a share per month, but its earnings were declining along with cash flow, leading several analysts to downgrade their outlooks. Its long-time CEO Jeff Immelt had already announced his upcoming retirement and subsequently announced his departure from the board of directors – where he was chairman – earlier than expected. Meantime, the stock’s dividend yield kept climbing, to more than 5%, as its stock price continued to fall.
“Just going with large established businesses these days is not good enough,” says John Gomez, president of Santa Barbara Asset Management.
Investors interested in dividend-paying stocks need to distinguish between companies that pay high dividends and companies that grow their dividends, says Jeff Chang, the chief operating officer of CBOE Vest.
Consistent dividend growth is a better indicator of a company’s financial strength than high payouts, and dividend growers tend to outperform dividend high payers over time, Chang says.
Free cash flow, the amount of operating cash flow minus capital expenses, is key to assessing a company’s ability to maintain and grow its dividend. Does it have enough free cash flow to support its dividend, and a possible dividend increase?
GE clearly did not. Its cash flow had been declining since 2013 and its dividend payout equaled more than 100% of its cash flow and more than 100% of its net income.
How can investors recognize the next GE?
- Consider the yield. “If the yield seems too high, it’s probably too good to be true,” says Jim Boothe, chief investment officer of Santa Barbara Asset Management.
- Consider the sector. What’s a high payout ratio — dividends relative to earnings — in one industry isn’t necessarily high for another, and certain sectors like retail are under pressure. Payout ratios in retail are generally around 30% to 40%, but for utilities they’re close to 60%, Boothe says.
- Then compare stocks within a sector. Kohl’s (KSS), for example, has a 5% dividend yield but a dividend payout ratio of close to 60%, while Macy’s (M) pays a dividend above 7% but its dividend payout ratio is just under 45%. Macy’s dividend payout is high but Kohl’s is excessive, Boothe says.
“What matters are the fundamentals to support the valuation,” says Gomez.
Non-diversified oil and gas exploration companies, for example, generally lack stable fundamentals because oil prices are volatile and oil demand is expected to decline long-term, but diversified companies like Chevron and Exxon can support their dividend and have been growing their payouts. They are members of the Dividend Aristocrats of the S&P 500, currently 51 stocks that have been increasing their dividends every year for 25 years.
That’s not a bad list for investors who want to own dividend-paying stocks but they need to be more proactive, monitoring individual stocks, even if stocks have a history of rising dividends, says Boothe, who manages the Nuveen Santa Barbara Dividend Growth Fund (NSBAX).
“We want our portfolio to have faster dividend growth, and a dividend yield above the S&P 500's yield.”
That doesn’t mean, however, that all the stocks need a history of rising dividends, Gomez says. “What matters are the fundamental underpinnings.”
--- Related on ThinkAdvisor: