Looks like it was the right move. As of this writing, the stock is down another 25% from my selling price. Worse, the company recently reduced its interim dividend by 75%.
Double whammy
By no means was I the first to highlight trouble at Tesco and plenty of observers have offered reasons for the company's decline. My focus here will be on the dividend.
Frankly, I'm still a bit stunned at how Tesco's turned out and think its dividend cut serves an important case study for dividend investors to review.
Consider that in fiscal year 2011 (year-end February 2011) Tesco increased its dividend by 10.8% -- marking an impressive 27 consecutive years of dividend increases. Well-respected long-term investors like Neil Woodford and Warren Buffett held considerable positions in Tesco and its UK market share was over 30%. All seemed to be right.
The board and management also appear to have been very confident in the future of the business, otherwise they wouldn't have increased the dividend at such a high rate in fiscal 2011.
With the exception of a financial crisis-scenario, rarely does a company have such a sharp reversal in dividend policy. Yet that's exactly what happened at Tesco.
In fiscal year 2012, the dividend grew just 2.1%. The next year, it was held flat and stayed at that rate until it was finally cut in August 2014.
Source: Company filings
The company's dividend health, as measured by the Dividend Compass, was also deteriorating.
While some warning signs were present, the combination of Tesco's distinguished dividend track record, its real estate holdings, and its leading share of the UK grocery market remained for some compelling reasons to hold and hope for a dividend turnaround.
Yet the numbers didn't lie. Tesco's dividend health slowly worsened, the dividend yield steadily increased to more than twice the UK market average (usually a good sign that something's wrong), and it was only a matter of time before the board needed to make some tough decisions.
Lessons learned
The first takeaway from Tesco's dividend cut is a reminder that no dividend is risk-less or sacrosanct. In the UK market, Tesco was a core holding in many dividend portfolios (including mine for a while) and up until a few years ago its payout was about as much of a sure thing as one could expect. Yet in a matter of three years Tesco went from dividend aristocrat to dividend plebian. If worse comes to worse, the board can always cut the company's dividend.
Second, it's critical to not "buy and forget" your investments. I know some well-intentioned dividend strategies advocate this approach and while I certainly appreciate the value of patience and keeping trading costs to a minimum, what happened with Tesco serves as an example of why some level of maintenance research is needed if you hope to avoid dividend cuts.
The combination of a permanent capital loss and a dividend cut can have a material impact on your longer-term income returns and you'll have less capital to reinvest in another dividend-paying stock. If you can catch a dividend cut early, you have much higher odds of preserving more of your capital.
Third, no matter how strong the company's dividend track record, if the numbers don't add up, it pays to be skeptical. Admittedly, I held onto Tesco a little too long thinking that it would simply take some time for the company to right the ship. When in doubt, preserve capital.
Fourth, while most dividend-focused portfolios are diversified, the Tesco share price decline and dividend cut is a reminder that it's important not to rely on any one stock (or one sector) to generate a large percentage of your dividend income.
Finally, even if you're a patient investor, it's important to establish some selling rules. For example, one rule might be that if a company's dividend growth trajectory radically changes for the worse or is altogether halted, it's time to sell. In such a situation, it's highly likely that company leaders have changed their opinion about the company's ability to generate higher levels of cash flow.
What do you think? Let me know on Twitter @toddwenning
As the saying goes, the most valuable investing lessons are learned from observing other investors’ mistakes. Or something like that.
Well, have an investing lesson on me, as I’ve made a pretty decent mistake in my portfolio. Earlier this week, I made the very difficult decision to close my three year investment in UK-based grocer and retailer, Tesco plc (LON: TSCO) and realized a 22% loss on capital -- just the type of permanent loss that we're trying to avoid. Granted, the generous income return from the Tesco investment lessened the sting of the capital loss, but the investment performed poorly on an absolute basis -- and even more so if we’re measuring it relative to the market.
These things happen, though. Let's at least learn something from it.
So, what went wrong? Looking back, my original thesis was reasonable. Tesco had steadily increased its dividend each year for well over a decade, margins stayed in a tight range, the new management team seemed capable, etc. The trouble started a year or so into the investment when I didn’t follow my own selling advice and held on while the thesis deteriorated. Two prongs of my initial thesis on Tesco were that the company’s mis-timed expansion in the U.S. (Fresh & Easy) would eventually stabilize and rebound as the U.S. economy recovered -- particularly in the western states where the stores were located. Further, I thought Tesco’s investments in China would fuel earnings and dividend growth for years to come. Neither of these things worked to plan. In April 2013, Tesco announced it was exiting the U.S. market and Fresh & Easy filed for bankruptcy protection. All of this resulted in a over a billion dollars in trading losses and impairments. That in itself should have been a sign to sell.
I rationalized, however, that with the Fresh & Easy chapter finally shut, Tesco could better focus on its other global operations.
Strike one.
Tesco also never figured out how to turn a steady profit in China. Ultimately, Tesco entered into a joint venture with a large Chinese retailer who actually knew how to run a retail business in China. So much for the region fueling dividend growth.
Strike two.
With Tesco’s focus on its struggling international operations, it began losing ground to competitors in its home market. Indeed, a space race/pricing war erupted between Tesco and other U.K. grocers like Sainsbury's and Morrisons. Meanwhile, discounters and higher-end grocers feasted on the opposite ends of the spectrum.
Even though Tesco seemed best suited to survive his war of attrition, profit margins have suffered. This put further strain on both free cash flow- and earnings-based dividend cover. In response, Tesco’s held its dividend flat for the last two years and recently abandoned its profit margin target.
Strike three.
As an aside, when I first invested in Tesco, two of my favorite investors (Neil Woodford and Warren Buffett) owned the stock. Buffett even increased his stake a few months after I invested, which I believed supported my thesis. Around the same time, however, Woodford was paring his investment in Tesco after owning the stock for well over a decade. (Buffett would later reduce his holding, as well). I might have paid too much attention to this factor. Certainly having top-notch investors on the same side of an investment can be reassuring. They've also done the research and think this particular stock is a good investment. Still, it's important to remember that their motivations for owning the stock could be very different from yours. Why not be patient? The purpose of the Clear Eyes Investing blog is to promote long-term and patient investing. It’s important, however, not to confuse patience and hope. In investing, patience is allowing the companies in your portfolio (that you bought at good-to-fair prices) to compound returns through their advantaged business models. Hope, on the other hand, is a wish or desire for something to occur when the fundamentals don't add up. I fear I may have been “hoping” for a Tesco turnaround a bit too long. There’s little point in hoping that a stock price will return to your cost basis if new information suggests otherwise. As such, it's important to revisit and refresh your assumptions every so often. Using a back-of-the-envelope H-Model (H-Model explained here) and plugging in a range of what seem to be reasonable scenarios, I didn’t like what I saw:
*Just noticed the typo -- should be column and row, not column and column.
This is an admittedly simple valuation model, but it does suggest that even at 290p per share, Tesco may not be cheap right now. That's certainly the case if the company doesn't resume mid- to high-single digit annual dividend growth.
And a resumption of dividend growth seems unrealistic considering Tesco's current yield over 5% (~1.7 times the market average), lack of free cash flow cover, and no apparent end to the UK grocer pricing war. I don’t see any reason why Tesco will have the desire nor the financial ability to restart its dividend growth in the near future. As a check on my dividend outlook, I plugged Tesco’s most recent financials into the Dividend Compass. I wasn’t impressed by the results as the score has declined to very low levels.
In recent years, Tesco's supported its dividend through real estate monetization (i.e. sale and leaseback arrangements, etc.) and not via free cash flow generated through operations. Put simply, that’s not a sustainable strategy. Tesco’s dialing back capital expenditures in the next few years to improve free cash flow, but it’ll also need to grow cash flow from operations if it’s going to consistently cover the payout with free cash flow.
Tesco’s closest peers like Sainsbury's and Morrisons are also trading with dividend yields over 5% and I have some concern that if one of them decides to cut their payout, the others will be more inclined to follow suit.
Tesco shares may in fact turn around and I might be wrong in selling here, but fresh analysis suggests it’s the right move. Time will tell, of course, and I'll look to reallocate my cash elsewhere.
Lessons learned At the very least, I hope my financial loss provides some valuable lessons and that we can use them to improve our investment processes. Here are five key lessons/reminders that I’m taking from this case:
When you find yourself making a lot of excuses for a company’s missteps, it’s time to reevaluate your investment thesis. Remember, you don’t work for the company and there’s no reason to spin bad results in a positive light. Call them as you see them.
If a company holds its dividend flat after years of steady growth, it’s likely a sign that the competitive landscape and/or company’s strategy has changed. The board and management are clearly not confident in their medium-term outlook. Something is up.
When figuring out when to buy or sell a stock, don’t concern yourself with which investors are also buying or selling the stock. Fund managers with large assets under management can have very different investment criteria and objectives than you and I do. They can also make mistakes like anyone else.
Forget the price you paid for the stock. The question you need to answer is, “Would you buy the stock today?” Anchoring is a powerful behavioral bias. To combat anchoring, write down your original thesis and periodically review it and update your assumptions. Has anything materially changed?
Even a solid research process can have a poor outcome. On average and over time, a good process should yield better results, but on a case-by-case basis this isn’t always true. Learn from the poor outcome and move onto the next investment.
Please post any questions or comments you have in the comments section below. Good reads this week
A 1929 article about one of my great-grandfathers who was a beloved street car operator in Cincinnati.
Quote of the week
At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business; it’s better to have a partial interest in the Hope diamond than to own all of a rhinestone. -Buffett
Over the last two weeks, we've been searching for promising dividend growth stocks that trade on the U.S. markets. Our original objective was to identify "quality dividend-paying small- to mid-cap companies with sustainable competitive advantages and the potential for 7%+ annual dividend growth over the next 7-10 years." After running a broad screen to reduce the number of initial contenders, we put six companies through the Dividend Compass spreadsheet to get a better feel for the health of the companies' dividends. Of course, all of that work was based on historical data. Today, we'll dig deeper into the two finalists -- MTS Systems and WD-40 Company -- to determine how those names might perform going forward. Further, the research we've already done shows that both companies have solid balance sheets, are consistent generators of free cash flow, and have established good dividend track records. As such, we won't spend too much time digging into those data points today. Instead, we'll look at the two companies' competitive advantages (if they indeed exist), management quality, and consider their current valuations to determine whether or not they're worthy of investment right now. The finish line is in sight After digging into WD-40 and MTS this week, it's clear that the screening and Dividend Compass process uncovered two promising companies. Indeed, they check off a number of Peter Lynch's 13 signs of a perfect stock. Among them: little analyst coverage (officially, MTSC has two analysts, WDFC has four analysts), they each have a niche, and the companies are buying back stock (though this isn't always a great thing, in my opinion). As with most endeavors, the hardest part of the investing process is the last stretch. Most investors go through the screening process and read historical financial statements. Where you can separate yourself as an investor is in this last stretch of research -- digging for the qualitative factors and getting a feel for valuation.
MTS Systems (MTSC)
What does the company do?
MTS Systems supplies test systems and industrial sensors to a number of end-markets such as the automotive, aerospace, fluid power, and manufacturing sectors (i.e. mostly cyclical industries). About 80% of revenue comes from the test segment, which designs force and motion systems for determining a new product's mechanical properties; MTS commands a 16% market share of the global testing product and service industry. The sensors segment helps customers improve the efficiency and safety of their automated manufacturing processes and also measures fluid displacement and liquid levels; MTS has a 6% share of the global sensors market.
Source: MTS
MTS also has a wide geographical reach, with an established presence in the world's major manufacturing centers.
Source: MTS
Does it have sustainable competitive advantages?
Historical financials seem to suggest that MTS has a sustainable competitive advantage. It may lie in the "mission critical" nature of its products. Firms investing many millions of dollars in large industrial products simply cannot afford to forgo strenuous mechanical and fatigue testing before rolling the new product out to customers. The warranty or recall risk from a flawed piece of equipment may well outweigh the testing cost. Further, some products may be required to undergo such testing due to government regulation. But these could simply be industry-level advantages rather than a specific advantage to the firm.
Where MTS may set itself apart is with its established brand and reputation in the industry for doing quality testing, particularly for larger-scale projects. I'd imagine that most smaller-scale product testing can be done internally and that the competition for smaller-scale projects is pretty fierce. Larger-scale testing projects can last up to three years, however, and there are probably only a few companies that can handle such work -- MTS being one of them -- and customers are unlikely to switch providers halfway through the testing period. As such, I'd say MTS has a slight advantage stemming from switching costs for larger projects, but the depth of the moat will fluctuate along with demand for these larger-scale projects.
How about management?
The MTS leadership team is relatively new, by which I mean less than two years in their roles. It seems a few years ago that the company got in a little trouble regarding some disclosure items relating to government contracts. This appears to have been one of the primary drivers behind the August 2011 resignation of the former CEO and the re-shuffling of the executive suite. Such dramatic moves are necessary when there's been an ethics issue, but it also likely means that the company will be in transition mode for a few years. Unless you know a lot about the new management team (I don't) and the effect the changes are having at the ground level (again, I don't), it's hard to make a bold turnaround call (so I won't).
Short-term cash bonus metrics are based on EPS, EBIT, revenue, and orders. Not my favorite set of metrics, but not terrible given that MTS remains squarely in the growth stage of its lifecycle. In time, I'd prefer to see less emphasis on top-line growth and more emphasis on free cash flow and profit growth.
Biggest concern?
With 40% of testing orders coming from Asia, I have some concerns regarding the Chinese economy -- specifically, how the shift from an investment- and manufacturing-driven economy to a customer-driven one may affect demand for MTS's testing services in the region. MTS aims to double its revenue to $1 billion by 2018 and robust demand from the Chinese market will likely be necessary to achieve that goal.
Is it a good buy today?
MTS's average return on equity over the last five years is about 18% and its dividend policy is to pay out approximately 30% of earnings, implying a back-of-the-envelope sustainable growth rate of between 12-13%. Not bad against a P/E ratio of 18.6 times (~1.5 PEG), but not a slam dunk, either.
Doing some DCF work on MTS with a range of reasonable growth assumptions, I'd put a base case fair value near $60 per share, which is in-line with today's market price. I'd need a margin-of-safety of at least 20% with this type of business, so a good entry point might be closer to $48.
MTS is definitely a good one to watch in the event of a market pullback and there's significant dividend growth potential, but given my uncertainty around its sustainable competitive advantages and a newer management team, I wouldn't make it more than 2% of my portfolio.
WD-40 Company (WDFC)
What does the company do?
Anyone who's spent time in a garage, fixing squeaky hinges around the house, or worked on bicycles has likely used a WD-40 product. In fact, the vast majority of the company's revenues are based on the original WD-40 formula (WD-40 stands for “Water Displacement perfected on the 40th try”) and the company's documented over 2,000 uses for the secret formula. The company also owns a number of related consumer/industrial cleaning products such as Lava soap and X-14 mildew stain remover. Its products are sold in 187 countries, so the company does have a wide geographic reach (about 40% of sales are U.S.-based).
Does it have sustainable competitive advantages?
For starters, the WD-40 brand name is extremely valuable. I can't even name a substitute product. It's a trusted brand, can charge a premium price, and I'd even argue that there's a slight emotional connection to the brand (i.e. "this is the brand that my dad always used in the garage"). Beyond the brand, the company's ability to build upon a single secret formula and create multiple products is an example of economies of scope. This results in a cost advantage that would-be competitors would struggle to match if they attempted to go head-to-head with WD-40 on a certain product line.
Source: WD-40
The company's ability to consistently generate double-digit returns on capital is another indication that an economic moat is likely present. Finally, another telling statistic: in 2012, WD-40 generated nearly $1 million in revenue per employee. I like to see at least $250,000 in revenue per employee, so this is definitely a sign of a strong company.
How about management?
One thing that I really like about WD-40's management team is that all seven corporate officers been with the company for more than 15 years. My personal preference is for the companies I own to promote from within and to have a deep bench of talent in the event an executive leaves or retires. This is particularly true for a company with a strong corporate culture, as it supports cultural continuity. Now, a company with a rotten corporate culture may need to hire an outsider to shake things up, but all else equal I prefer internal promotion in the executive suite.
CEO Garry Ridge has been with the firm since 1987 and the CEO since 1997. During his tenure, the stock is up 319% cumulative, or about 9.2% annualized, compared to a 200% gain, or 6.9% annualized, for the S&P 500 over the period. The stock's also outperformed the S&P 500 by about 40 percentage points over the last five years. All this is to say that long-term shareholders should be fairly happy with the way the company's performed under Ridge's leadership. WD-40 also keeps the chairman position separate from the CEO role, which is textbook best practice for corporate governance.
I'm not crazy about management's bonus incentives, which are primarily linked to EBITDA. EBITDA is one of my least favorite financial metrics (Buffett called trumpeting EBITDA a "pernicious practice" in the 2002 letter; Munger called it "(expletive) earnings") because interest, taxes, and depreciation are natural and recurring shareholder expenses that shouldn't be ignored. I could rant on about EBITDA, but I'd much prefer this otherwise high quality company to use more shareholder-focused incentive metrics such as net income, free cash flow, and/or economic value added (EVA).
Biggest concern?
A potentially limited growth runway. With its products already in 187 countries and a sizeable portfolio of products already built around the WD-40 brand, what will drive top-line growth in the medium-term? I have no doubt that consumers will continue to buy WD-40, but can the company deliver high-single digit/low-double digit earnings growth without becoming more active on the M&A front?
Is it a good buy today?
WD-40's consistency and high quality hasn't been overlooked by the market and the stock has historically traded at a premium. WD-40's five-year average P/E is 19.1 times versus 17.2 times for the S&P; today it's trading at 22.7 times. Not exactly cheap on that basis. But what about growth? Based on the company's five-year average return on equity near 19% and its dividend payout ratio near 50%, the "sustainable growth rate" is about 9-10%. An implied PEG ratio near 2x isn't great, either. Its current dividend yield of 2.1% is also well-below its five year average closer to 3%.
Running a quick valuation on WD-40, I put a fair value on the shares at $52 (currently $58.52). I'd look to buy with at least a 15% margin-of-safety, so a good buy-around price today would be $44.
I really like WD-40 as a company. Hopefully the EBITDA-based incentive metrics go away, but otherwise I'd be happy to own WD-40 in the event of a market pullback. Ideally, I'd like to pick up the stock with a yield closer to 3%, which is about what I'd get if the stock traded near $44.
Bottom line
MTS Systems and WD-40 are both intriguing dividend growth candidates, but neither appears to be a good value at the moment. MTS has more dividend growth potential than WD-40, but also carries more risk.
All in all, I think this was a worthwhile exercise. We dug into two promising dividend growth opportunities and now have two good names to keep on our watchlists.
What do you think? Please let me know in the comments section below. Note: I switched the comments format back to the normal setting as the Google+ format was simply not working well. You can also reach me @toddwenning on Twitter.
Last week, we set up a simple stock screen with an objective of "Identifying quality dividend-paying small- to mid-cap companies with sustainable competitive advantages and the potential for 7%+ annual dividend growth over the next 7-10 years." We then employed a five-minute "sniff" test to determine which of the companies deserved a closer look. This week, I ran each of last week's six surviving stocks through my Dividend Compass* spreadsheet (free to use and download) in order to get a better feel for the companies' underlying dividend fundamentals. Of this group of six, I'll choose 2-3 for a deep-dive (competitive analysis, valuation, etc.) in next week's post. If they end up being good buys right now, I'll put some money into them. If not, I'll keep them on my watchlist. The results, please... Here's how each of the six companies fared on the Dividend Compass (scores out of 5):
*Used 3 year average due to shorter dividend history
Computer Programs & Systems: CPSI has the highest yield of the lot and scored very well in most of the Dividend Compass categories. It fell short where it counted, however, particularly in the dividend cover categories. Over the last five years, for instance, CPSI scored either a 1 or 2 in free cash flow cover -- the highest-weighted factor. Earnings cover was just slightly better. CPSI also held its quarterly dividend at $0.36 per share between February 2006 and November 2011. Combine these findings and it seems like CPSI has generally lived on the edge with its dividend payout.
The debt-free balance sheet is attractive and I give the company credit for not cutting its dividend during the financial crisis, but the consistent lack of dividend cover makes me a little nervous for a high-yield stock, let alone a dividend growth stock. A year or two of bad results and the dividend could be at risk. At best it would be held steady, which isn't an ideal scenario for a dividend growth investment.
Quality Systems: QSII's stock is up nicely over the last two months, but it has dramatically underperformed the S&P 500 to the tune of 80+ percentage points over the last two years. The dividend has also been held at $0.175 per quarter since March 2011. In short, something isn't quite right here. Underlying dividend health has also deteriorated as margins and returns have suffered over the last eighteen months. Though the five-year average score is decent, recent results are reason for concern.
Compass Minerals: One of the reasons that I look at multi-year scores is that some companies are in cyclical industries and results in a given year may not be representative of the company's dividend health. Compass Minerals is one such company, as much depends on the severity of winter weather in North America (for the salt business) as well as potash pricing. In good years, the dividend is well-covered by free cash flow and the balance sheet looks pristine, but dividend health deteriorates a bit in down years. Over time, however, the 3.91 of 5 score on the Dividend Compass is pretty good. I have some concerns about the changing competitive dynamics within the potash industry, but as a current shareholder I have long-term confidence in the business's prospects. Innophos Holdings: Having IPO'd in 2006, chemicals company Innophos has a fairly short dividend track record that begins in January 2007. Further, its quarterly payout was held steady at $0.17 per share from April 2007 to January 2011, but has since increased at a decent clip. The nearly four-year hiatus from dividend growth is a definite negative, but the other dividend health metrics have been consistently strong. Over the past twelve months, however, profit margins and returns on capital have been disappointing, so if Innophos passes onto the next round I'll need to figure out if this is a temporary issue or the start of a bad trend. WD-40: As I mentioned in last week's post, WD-40 is a company that I've had my eye on for some time. I really like the corporate culture -- the company has near-perfect employee reviews on glassdoor.com -- and it has over 100,000 members in the WD-40 Fan Club. The company scored a little below what I had expected on the Dividend Compass, dragged a bit lower by underwhelming dividend growth over the last three years. Instead, the company has increased its buyback activity, which I'll need to look into further if I pass the company into the next round. MTS Systems: Of the six companies that made it to this round, MTS Systems had the highest Dividend Compass marks including an almost perfect score in calendar year 2012. The 1.9% dividend yield is a bit pedestrian, but the balance sheet is very strong and the company has generally produced more than enough free cash flow to cover the dividend while increasing its payout over time. I do have a few concerns about recent performance that will need to be addressed if MTS Systems proceeds to the final round.
Who made the cut?
The Dividend Compass revealed a lot about each stock in about 10-20 minutes, which I think saved a good deal of time by not needing to spend an hour-plus reading through each company's annual reports. By not having to conduct a deep-dive on six companies, I can now focus on 2-3 names in the next round.
I'm not putting CPSI through to the next round. Even though CPSI had the highest yield of the group, I simply can't get past the consistently-low dividend cover.
CMP is a very well-run company and I believe it is an attractive candidate for further research, but because I already have a position in the company and want to learn more about recent developments in the potash industry, I'm going to hold off on doubling-down on it.
QSII might be a really interesting research subject from a value/turnaround opportunity standpoint, but the fall-off in margins and returns over the last eighteen months makes me concerned that there's been a significant change to the competitive dynamics within the industry. The recently-stalled dividend growth also gives me pause. As such, I'm not putting QSII through to the next round.
I'm also not moving forward with IPHS on account of its relatively short and unproven dividend track record, but its DC numbers were good and I'd definitely consider looking into it down the road.
I started out thinking that WDFC would be a sure-thing to make it into the final round, but I was disappointed with its score on the DC. I went back-and-forth on this one a bit, but decided to pass it through to the next round as I think it's a fascinating company to discuss. One of the key research topics will be why dividend growth hasn't been as robust as it perhaps could have been in recent years.
MTSC's strong DC scores were a nice surprise and I'm also going to put it through to the final round. Results have been a little shaky recently, but we'll figure out next week if those are temporary issues or not.
Low yields
Both companies' yields are around 2%, which isn't much to write home about, but the yields are comfortably above the Russell 2000 yield of 1.4%, and at first glance, both businesses appear to have the potential for 7%-plus dividend growth over the next decade. At the very least, they're worthy of further research.
In the concluding post of this three-part series, we'll take a much closer look at WDFC's and MTSC's businesses and do some valuation work on them, as well.
Thanks for reading and please post any comments, questions, or criticisms below. You can also contact me on Twitter @toddwenning or by email here.
*Frequent users of the Dividend Compass will note that I have recently blocked out a few of the input categories from 2004-2006. Those data points don't have an effect on the Dividend Compass scoring system and I wanted to eliminate some of unnecessary fields. Please let me know if you have feedback on this.
First off, thank you to everyone who has already taken a look at the Dividend Compass spreadsheet (which you can view and download for free by clicking here).
If you haven't the faintest idea what I'm talking about -- a forgiveable oversight :) -- here's an earlier blog post that explains the Dividend Compass and how it works.
Also, a special thank you to those of you who have provided valuable feedback on the Dividend Compass -- in particular to Pablo, who noticed a broken formula that has since been fixed.
Since we're nearly finished with 2012 (hard to believe!), I've added a column for trailing-twelve month (TTM) figures so the data is as fresh as possible.
Roll up our sleeves
Today, I'd like to illustrate a few ways in which you can use the Dividend Compass to notice trends in dividend health and growth potential.
The default company in the Dividend Compass is Johnson & Johnson* (a stock I own), which also happens to be a great example for trend-spotting.
Here's how the Dividend Compass results tab looks today:
Setting aside the weights and final score aside for a moment and focusing on the line items, we can quickly recognize a few trends.
On the positive side, operating margins remain solid, the balance sheet (based on interest coverage and net debt/EBITDA) remains in excellent shape, and the dividend looks sustainable on a free cash flow cover basis.
Unfortunately, the negative trends appear to outweigh the positives. Sales growth, dividend growth, earnings cover, and return on equity have all declined by at least two full Dividend Compass points since 2008.
Devil in the details
A glance at the results that feed into the Dividend Compass confirms these trends:
Recognizing these trends helps us focus our research. The negatives may or may not be as bad as they seem, but we do need to dig a little deeper to determine if the trends are genuine concerns.
On the slowing sales growth issue, JNJ has been adversely impacted by a few drug patent expirations, but relative to other major drug producers facing patent cliffs, JNJ's top-line isn't all that bad. JNJ's top-line has also been supported by consumer healthcare and medical device businesses. Still, the slowing growth is an issue to consider.
The declining earnings cover and ROE issues are linked as both metrics have been driven lower by the substantial litigation, product recall, and write-down expenses the company has taken over the past two years.
Excluding "one-time" charges like these, management expects 2012 adjusted EPS to be $5.05-$5.10 per share, which would equate to dividend cover near 2.1 times and implies an adjusted ROE of approximately 22-23%. In this light, things don't look quite as bad as the Dividend Compass score might suggest as the data is based on reported results and not adjusted results.
There's reason to believe that these expenses won't be recurring items, but the substantial charges have nevertheless impacted results as evidenced by slowing dividend growth and JNJ's relative under-performance over the period -- since the end of 2008, JNJ's share price has trailed the S&P 500 by 34 percentage points (SPY: +69.5%; JNJ: +35%).
However you view them, these one-time expenses matter and should be fully considered.
Bottom line
Whether or not you think there's cause for concern in this particular case, the Dividend Compass has helped us identify trends that required our attention. In some cases, we may find there's not a good explanation for the trends we see and that could be a sign to stay away or sell an existing position.
Hope you're having a great weekend and thanks for reading!
Best,
Todd
@toddwenning on Twitter
*This is not meant to be a full analysis of Johnson & Johnson nor is it an endorsement of the stock, but is meant to illustrate how the Dividend Compass can be used in your regular research. Further research is always necessary.
There's no question that dividend-paying stocks have become more popular in recent years as interest rates on fixed income and savings products declined.
Indeed, dividend-focused ETFs and mutual funds have experienced strong inflows, some higher-yielding stocks in rather staid industries (tobacco, utilities, etc.) are trading with multiples above their five-year averages, and gross S&P 500 dividend distributions will almost certainly hit a record high in 2012.
Contrarian investors will naturally raise an eyebrow or two at these developments.
Time to bail?
The heightened interest in dividends has led to some speculation that a "dividend bubble" might be afoot. As you might expect, massive debate has ensued among pundits, normally with the author taking a firm and uncompromising stance on one side or the other.
The problem isn't that either side hasn't made fair observations, but that the debate is all too frequently framed around whether or not there is in fact a "bubble" -- definitely the most overused term in financial media -- and misses the fruitful middle ground, leaving the reader without any actionable guidance ("Great, there is/isn't a dividend 'bubble'. What now?")
Instead, I find it far more instructive to critically examine the landscape as it stands today without being handcuffed to the bubble framework.
Is there "irrational exuberance" for dividend-paying stocks today? Relative to the exuberance we saw with dotcom stocks or housing, absolutely not. If there were, I don't think you'd see this trend in U.S. payout ratios.
Aswath Damodaran, Standard & Poors
It stands to reason that if investors really were falling over themselves to buy dividend stocks, companies would respond by paying out a greater percentage of earnings as dividends, so as to attract more investor interest. While some companies may have accelerated their dividend payouts for this reason, on average, that's not happening.
Instead, S&P 500 companies used buybacks over dividends to return cash to shareholders by nearly a 2:1 ratio in the second quarter. The trailing 12-month S&P 500 dividend payout ratio stands at just 32%.
Source: Standard & Poors
Might some institutional investors be using buybacks to 'create' their own dividends? Maybe, but you could have just as easily have made the case for that in 2007 when dividends certainly weren't in style.
And yes, aggregate dividends of $67.31 billion in Q2 2012 set a record -- finally eclipsing the previous record of $67.09 billion set in Q2 2007. Flat nominal dividend growth over the course of five years is hardly an indication that corporations are opening the spigots to satiate investor appetite for dividends.
Are some dividend-paying stocks overvalued today? Yes. Judging by the multiples on some low-growth, high-yielding stocks today, I think it's likely that income-thirsty investors have in some cases reached for yield and bid the share prices above their fair value.
Similarly, so-called "quality" dividend-paying stocks -- that is, stocks with long track records of raising payouts each year (Aristocrats, Achievers, etc.) and investment-grade balance sheets -- as a group seem to be fully valued.
Are all dividend-paying stocks overvalued today? No. I think there's likely more value to be found in the lower-yielding areas of the market, as investors who are solely interested in current income are focused on the higher-yielding stocks and may not have the time horizon or interest to wait for the dividend to grow over time.
Where might there be value left among dividend-paying stocks? Investors who have just started building a dividend-focused portfolio are not likely to find many deep value opportunities in the high-yield or traditional "quality" space right now.
The most fertile ground for moderate- to high-yielding stocks today is likely found in stocks that have just recently started paying dividends (as they're not yet included in Aristocrat/Achievers screens and trackers), stocks that may have cut their payouts during the financial crisis but are on the path to recovery, and in smaller-cap stocks where the large funds are less likely to hunt for yield.
Bottom line
While there isn't a dividend "bubble", I will say that most of the low-hanging fruit has been picked. As such, you'll need to do a little extra homework if you hope to land some undervalued dividend-paying stocks with relatively good yields right now. It's no longer as simple as picking 12-20 stocks that everyone knows with investment-grade balance sheets and decades-long dividend track records. Yet there are still opportunities out there for investors willing to do the extra work.
(If you need a little help analyzing the stocks you come across, my free Dividend Compass tool can help you with your research.)
As always, stay disciplined and patient out there.
When it comes to equity analysis, a lot of attention is paid to valuation -- and rightly so, as your investing career will likely be a short one if you consistently overpay for assets.
Surprisingly, however, there's typically little attention paid to dividend analysis, which usually begins and ends with a glance at the dividend payout ratio (or dividend cover). As long as the company is earning more than it's paying out, the thinking goes, all is well with the dividend; conversely, if the company is paying out about the same amount as (or more than) it's earning, the dividend is at risk.
There's more to it
While the payout ratio is important, in my experience, the main causes of a dividend cut are factors other than a high dividend payout ratio (or low dividend cover). Indeed, a high payout ratio is usually the result of past events and trends that have been in place for a number of years.
In fact, more times than not, the need to strengthen the balance sheet is the cited reason for a dividend cut -- creditors and ratings agencies get worried about a lack of cash flow and large dividends become an easy target for freeing up cash. In turn, a weak balance sheet is often the result of a deterioration in business strength over a number of years -- margins have contracted, growth has slowed, and free cash flow has dried up -- paired with over-borrowing or over-spending.
Early diagnosis is the key
So rather than just look at the dividend payout ratio, it seems prudent to take a more holistic approach to dividend analysis by considering other factors that contribute to dividend health, such as:
Sales growth: Sales are the life-blood of a company. If sales are drying up, that puts added pressure on profits and cash flows and thus the dividend, too.
Interest coverage (EBIT/interest expense): If a company is having trouble paying the interest on its debt, there's a greater chance that its creditors will get worried and raise the company's cost of borrowing, which could reduce net income. In a worst-case scenario, the dividend could be cut to accelerate the repayment of principal.
Net debt/EBITDA: This is a common measure ((Debt-Cash)/EBITDA) that creditors and ratings agencies use to determine credit quality and it's commonly used as a metric in debt covenants. A firm that has borrowed too much or is struggling to pay down its debt relative to its profitability is more likely to have a risky dividend.
Dividend growth rate: A slowing dividend growth rate could be a sign that the company is less confident in its future growth potential. Eventually, all companies' dividend growth rates decline, but you want to see a steady decrease over many years and not a sharp drop.
Earnings cover: Even though I don't think it's the best measure of dividend health, earnings cover (Net Income/Dividends Paid) remains the most common metric cited by both companies and investors alike, so it should be considered in any dividend analysis.
Free cash flow cover: Free cash flow cover ((CFO-CapEx)/Dividends Paid) is a better measure of dividend health than earnings cover because companies don't pay out earnings -- they pay out cash. As such, I'd rather look at a company's cash flows than net income.
Operating margin: A company whose margins are contracting could be facing increased competitive pressures or becoming less efficient. When this occurs, less money falls to the bottom line and to cash flows and the dividend can become riskier. Cyclical companies' margins will naturally ebb and flow. In those cases, use rolling 5-year margins to account for the business cycle.
Return on equity: Companies that are unable to sustainably generate returns above their cost of equity are likely destroying shareholder value and usually have lower growth potential. Neither are good things from a dividend perspective.
Dividend Compass Tool
With this framework in mind, I tried my hand at a new (and hopefully improved) spreadsheet model for rating the health of a company's dividend. I'm calling it the Dividend Compass, and you can access and download it for free by clicking here.
(It's hosted on Google Docs for sharing purposes, but you can download it
to Excel by clicking on File>Download As>Excel on the top left
hand corner of the Google Docs page. Once you've downloaded it, you can make changes. If something doesn't work, please let me know in the comments section below.)
To get started, all you need to do is enter a few years' worth of key financial datapoints (sales, debt, etc.) -- all publicly available data -- on the Inputs tab and then click on the Dividend Compass tab.
The Dividend Compass (DC) will rate the company's dividend health based on metrics derived from your entries, with a 5 being a perfect score and 1 being the lowest. The overall score is based on the weighted average scores of the eight metrics and the default weights are based on what I believe to be the most important metrics. You can change them to fit your approach as long as they sum to 100%.
The DC will also grade the dividend going back a few years and provide a 5-year average score that will help you identify trends in the dividend's health. A falling score in any of the categoreis, for instance, may indicate a trouble spot that's worth looking into.
A few things to remember
I can't stress enough that the DC should not be used as a buy/sell indicator nor is it meant to be the final word on any stock. It's simply a research tool to help you tell the difference between a healthy dividend from a risky one, using a more holistic approach than traditional methods. Further research is always necessary before making a trading decision.
Dividend yield is not included as a graded metric in the DC. All else equal, I would expect higher yielding names to have lower scores and vice versa.
Finally, the DC is still in early days, so if you notice a bug or see room for improvement, please post a comment below. Questions and criticisms are always welcomed, too.
Hope you had a nice weekend.
Best,
Todd
@toddwenning on Twitter
(long JNJ, the default example in the DC spreadsheet)
Back in March, I explained why I sold my position in Tesco for a 22% loss.
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