General Electric’s November announcement that it would cut its highly popular stock dividend in half rocked not just Wall Street, but individual shareholders as well.
The news was especially difficult to hear for retirees living on a fixed income.
The dividend cut was only the second since the 1930s for GE, and comes at a time when cash is increasingly tight for the corporate giant. GE’s share price took a hit after the dividend announcement, and is down more than 40 percent this year.
The dividend cut will save cash-strapped GE an estimated $4 billion annually, but that’s no solace to company investors. They are left to wonder what happened to one of Wall Street’s safest “sure things” in the last 80-plus years.
Stock market experts, while sympathetic to investors, say the GE dividend slash is a good lesson for Main Street shareholders.
“With the GE dividend debacle still reverberating, it’s never been more important for investors to understand that not all dividend stocks are alike,” said Jeff Chang, managing director at CBOE Vest in McLean, Va.
Sometimes a company with high dividends can mislead investors, Chang said.
“Behind the dividend can lurk some disturbing accounting,” he said. “In the case of GE, for the last six years, the company had declining free cash flow. Companies in this situation may take on more debt and see declining earnings, putting both the dividend and stock price at risk.”
No Two Dividends are Alike
What should investors look for in dividend stocks?
First, understand the difference between dividend growers – companies that steadily grow their dividends over time – versus dividend payers.
The latter are “companies that try to attract shareholders with dividends that may be high, but could mask fundamental problems with the company,” Chang explained.
Here’s how Chang breaks the two dividend categories down:
• Are usually quality stocks with a strong history of outperformance, even during periods of market turmoil.
• Tend to have repeatable revenue sources (for example, AT&T has contract-based revenue), are diversified, and are not subject to variables such as cyclical raw materials prices.
• Free cash flow tends to be steady or increase over time.
• Often belong to sectors such as utilities, financials, energy and basic materials, which can generate high cash flows through their use of leverage.
• Frequently borrow aggressively in the marketplace.
• The borrowing can be used to fund an unsustainable dividend payout, suggesting the company is not as healthy as its dividend would lead you to believe. This represents a risk for stockholders. GE is a case in point.
When picking a dividend stock, it’s important to study the company’s financial statements to see the stability of revenue and dividend payout history, said Asad Gourani, founder and chief executive officer of AG Wealth Management.
“Chances are, an established company in sectors like utilities, where barriers of entry to the business are high, would have more stable revenue than say a retailer,” he said. “Also, with the rise of exchange-traded funds, the average investor could simply buy a fund that is geared toward high-dividend stocks rather than picking names and analyzing stocks individually.”
Another potential red flag with dividend stocks is weak cash flow, experts say.
“If a company has declining cash flow and/or their payout ratio is higher than 50 percent, I’d consider those major red flags and not recommend purchasing that dividend stock because it increases the likelihood of the dividend being cut,” said Robert P. Finley, principal at Illinois-based Virtue Asset Management.
Finley “always” looks at the cash flow of the company.
“I want to know what percentage of cash flash is being used cover the dividend payout,” he said. “This is referred to as the payout ratio and the rule of thumb is that a company should be using less than 50 percent of cash flow to pay dividends.”
‘Cash Flow Growth’
The next question focuses on the consistency and growth rate of the cash flow, Finley said.
“Typically, you want a company that is showing some growth in cash flow,” he said. “This cash flow growth would allow the company to grow the dividend in the future.”
A seemingly solid dividends-paying stock can quickly turn into a trap door that can derail a portfolio manager’s best-laid plans for his or her clients.
“Many investors make the mistake in selecting any company based on how high the dividend yield is, which is an investor’s trap,” said John Anagnos, chief investment officer at Aetolia Capital in Greenville, Del. “The dividend yield doesn’t matter if it’s 3 percent, but the stock is down by 10 percent.”
Instead, look at dividend yields as an added return that overlays a good company, which has good fundamentals, that lies in an overweight sector, he said. Ideally, the company also offers consistent dividend growth, he added.
“I’d rather own a stock that is up 15 percent and has a 2 percent dividend versus a stock that pays a 4 percent dividend but is up only 2 percent,” he Anagnos said.
Brian O’Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC’s Guide to Creating Wealth. He’s a regular contributor to major media business platforms. Brian may be contacted at firstname.lastname@example.org.
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