An Important Dividend Cut Case Study

Back in March, I explained why I sold my position in Tesco for a 22% loss.

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

What I've been reading this week

• A Q&A with Warren Buffett and some MBA students - Ben Graham Investing
• "Risk Revisited": the latest from Howard Marks - Oaktree Capital
• Knowing what you own (video) - Peter Lynch via ValueWalk
• Peter Theil's contrarian strategy - Fortune
• Why you shouldn't watch the market intraday - Abnormal Returns
• Asking the wrong question - A Wealth of Common Sense
• The tax dance (good primer on different US pass-through tax structures) - Aswath Damodaran

Stay patient, stay focused.

Best,

Todd

When Companies Aren't Committed to Dividends

Prior to 1982, when large-scale share repurchases became viable after Congress enacted rule 10b-18, nearly all shareholder distributions were returned via cash dividends. 

As such, companies with longer operating histories tend to have a tradition of paying dividends and their shareholders have naturally come to expect them to continue.

If given the chance, however, I suspect some of them would elect for a diminished dividend program in favor of buybacks, which offer substantially more financial flexibility and tend to benefit management and short-term investors.

Consider the following chart, which shows the rolling three-year percentage of U.S. shareholder distributions made via cash dividends versus buybacks.

Source: Birinyi Associates and FRB Z.1. (1985-87), S&P (2011-6/2013), author estimates 

What's particularly notable is that this trend developed despite equal tax rates on dividends and long-term capital gains since 2003, an increasing number of retiring baby boomers seeking income over growth, and strong demand for higher-yielding stocks in a low rate environment. 

All of these factors should have encouraged a larger share of shareholder distributions going to cash dividends, but that's not happening. Some companies are clearly not comfortable with making a larger commitment to their dividend program. 

We can discuss the reasons this might be the case in the comments section below, but you might be rightly wondering at this point, "Why does this even matter?"

As you're building a dividend portfolio, you want to stock it with companies that want to pay dividends. You don't want to own companies that feel burdened by their current payout, as these are the companies most likely to cut their payouts if given the opportunity.

Here are five red flags that a company may not be comfortable with its dividend policy:

1. Token dividend increases: If a company's raising its dividend by a small amount each year (less than 4% growth), it might mean that it is cautious about its prospects, or it could mean that the company is simply raising its payout by a token amount to maintain a tradition of raising payouts. In either case, this is not an encouraging track.
2. High leverage and high payout ratio: Firms with high financial leverage that are also paying out the majority of free cash flow as dividends might be concerned about their ability to maintain the current payout. In the event of an economic downturn or a shock to their competitive environment, the dividend could come under fire. Keep an eye out for "token" dividend increases from such companies. 
3. Excessive stock options in management compensation: The expected value of stock options decreases with the payment of dividends, so if the company's executive compensation program is heavily-weighted toward stock options, management may have a disincentive to paying higher levels of dividends. 
4. Short-term focused ownership: If a friend or colleague offered you an opportunity to buy a small equity stake in a local business, one of the questions you'd surely ask is, "Who are the other owners?" You'd want to know how the other equity holders think about the business, are their interests aligned with yours, etc., yet it's amazing how infrequently this question is asked before investors purchase stocks. Take a look at the list of the company's largest shareholders (outlined in annual filings), check out the fund managers' websites, and try to determine if they're long-term and/or dividend-focused. If you see a bunch of hedge fund owners, you might want to walk away from the stock.
5. An increasing preference for buybacks: Though buybacks properly employed can support dividend growth, you want to see a balance between dividends and buybacks over time. If the company is shifting from a balanced approach toward more preference for buybacks, it's a warning sign that the company is losing enthusiasm for its dividend program. 

As long-term, patient, dividend-focused investors, we want to own companies whose interests are aligned with our own. Recognizing the early signs of companies that are less committed to their dividend programs can help us better build our portfolios around the right companies.

Good reads this week:

• "Filtering Nonsense" -- Farnam Street 
• Understand All the Costs of Investing -- InvestmentMoats
• Investing in Lego - Monevator

Art of the Week:

My friend Anna's still life "Occhioverde"

Thanks for reading!

Best,

Todd

@toddwenning

Valuing Dividend Paying Stocks

Despite the increased interest in dividends these days, you don't hear much about dividend-based valuation methods.

While the more popular discounted cash flow valuation methods are instructive in their own ways, dividend-based valuation models are also worthy of consideration.

For one, dividend-based models measure actual cash outflows to the investor rather than potential cash outflows (free cash flow). In addition, they assume the perspective of the minority investor (you and me) instead of a controlling shareholder. Finally, dividend payouts tend to be less volatile than free cash flow on a year-to-year basis.

Like any valuation method, dividend-based models do have their drawbacks, the most obvious being the challenge of valuing non-dividend paying companies. Further, in order for a dividend model to be appropriate, there must be a clear relationship between the company's underlying profitability and dividend payout. The model is best applied to companies with a target dividend payout ratio (or cover), that pay out a significant percentage of earnings as dividends, and that have a track record of increasing their dividends alongside higher profits.

Putting it into practice 

Today, we'll use the dividend-based "H-Model" to value Coca-Cola. Before we start, I must stress that this exercise is for illustrative purposes only and not a recommendation to buy or sell Coca-Cola.

The H-Model formula may seem intimidating at first, but I think it will begin to make sense fairly quickly:

Value = (DPS * (1+gL)) + (DPS * H * (gS - gL))

        (r - gL)                      (r - gL)

Where:

DPS = dividends per share (trailing twelve months)
r = Cost of equity (10% is a good baseline for large cap, average uncertainty companies)
H = half-life of exceptional growth (i.e. if you expect 20 years of high growth, H = 10)
gL = Stable growth rate (shouldn't exceed 2-3%)
gS = Initial high growth rate

The first half of the equation represents the company's intrinsic value assuming stable growth going forward, while the second half of the equation captures the value of the company's extraordinary growth potential.

The H-Model assumes a linear decline in the company's dividend growth rate over time until it reaches a stable growth rate (the growth rate of the larger economy).

Let's jump right into it by plugging numbers and assumptions into the H-Model. We know for a fact that the trailing-twelve month dividend per share figure is $1.02. That's the one indisputable fact in the formula and the rest are the assumptions.

(The fact there are so many assumptions required in absolute valuation models may turn some investors off from them, but anytime you purchase a stock you're already making implicit assumptions about the company's future -- i.e. the assumptions baked into the market price. Might as well spell them out, in my opinion, and learn more about the company in the process. But I digress.)

• For years of extraordinary growth, it's important to consider the strength of the company's competitive advantages. Few companies will be able to grow their dividend payouts at a pace significantly higher than the economy's growth rate for thirty years, but Coca-Cola's brands and efficient distribution network are exceptional. Thirty years of above-stable growth may still be aggressive, but we can account for different scenarios later on. Most companies will fall into the 10-20 year range, again depending on the strength of their competitive advantages.
• For cost of equity, 10% is a good starting point for large companies with average uncertainty. A smaller company, or a large company with higher uncertainty, may require a cost of equity of 12% or more. Again, we can account for different costs of equity in a scenario analysis.
• The stable growth rate is the long-term growth expectation for the larger economy. In developed markets like the U.S., this shouldn't be more than 3%; 2% is a more conservative estimate. The reason the stable growth rate needs to approximate the long-term growth rate of the economy is that by assuming a higher growth rate than the economy, we're implying that eventually this company will become the economy. That's unlikely, unless we're talking about Google. :)
• Finally, for the initial high growth rate, you can base it on the average annual dividend increase over the past three or five years, the sustainable growth rate (discussed here), or the most recent dividend increase as long as it isn't too out of the ordinary. For Coca-Cola, we'll use the most recent dividend increase of 10% as a starting point.

The equation looks like:

Value = ($1.02 * (1 + 2%)) + ($1.02 * (30/2) * (10% - 2%))

                    (10% - 2%)                           (10% - 2%)

Value = $28.31

With this fair value estimate in hand, we can compare it to the current market price to determine if today is a fair buying opportunity. As of February 22, Coca-Cola shares traded for $38.52 --136% of our fair value estimate. At first glance, then, Coca-Cola does not seem to be an attractive buy today.

Based on Coca-Cola's 2012 EPS of $1.97, this result would imply a P/E of 14.8 times. This is significantly lower than the company's five-year average P/E of about 18 times.

Missing something?

As we know, buybacks have become an increasingly important way for companies to return shareholder cash. Even though we might prefer dividends to buybacks, it's nevertheless instructive to consider buybacks as part of the total payout per share, as buybacks can be considered part of a company's cash return to shareholders.

Because a company's buyback activity tends to ebb and flow over time, determining a reliable "buybacks per share" figure can be tricky. If you simply take buybacks in a given year and divide by shares outstanding, for instance, the baseline figure could be too high or too low.

Instead, I recommend taking a five-year average of total buybacks (found in the cash flow statement), add it to the most recent year (or trailing-twelve month) dividend payout, and divide that sum by shares outstanding to arrive at a "total payout per share."*

Since we are assuming a total payout per share figure that accounts for both dividend and buyback growth, we also must reduce our initial growth assumptions for the model. The reason for this is we're accounting for the company paying out a larger percentage of earnings to shareholders, leaving less to reinvest in the business. Holding return on equity steady, this would result in a lower growth rate.

For this example, we'll dial back our initial growth from 10% to 7%.

This result implies a P/E of 18.4 times, much closer to Coca-Cola's five year average.

For Coca-Cola, at least, it seems more consistent to include buybacks in the model since 42% of its distributions to shareholders came in the form of buybacks over the last five years. If we're just counting dividends, we might be excluding a meaningful amount of value in our estimate.

As long as the company hasn't consistently overpaid for its own stock or borrowed heavily to fund the buybacks, I have no problem including buybacks in the total payout equation.

Scenario testing

Regardless of which valuation approach you use (relative valuation, DCF, DDM, etc.), it's imperative to consider different scenarios, since your baseline assumptions will not likely come to pass.

Given the simplicity of the H-Model, we can quickly enter alternative inputs to establish a range of values:

In this example, I've kept the stable growth and cost of equity constant and tested the years of extraordinary growth and initial high growth rate variables, but you can certainly test the other variables, as well.

Get started, but be careful

Any time I write about valuation, I feel a bit like the mother from A Christmas Story after Ralphie gets his Red Ryder B.B. gun -- "Don't shoot your eye out!" A model that's inappropriately used can have negative consequences, so be sure to enter accurate historical data and use reasonable forecasts.

That said, give the H-Model a try on some of the companies on your watchlist and let me know how it works out for you.

Best,

Todd
@toddwenning on Twitter

*Hat tip to Aswath Damodaran for this method

Should More Companies Adopt Flexible Dividend Policies?

In the U.S. and U.K. markets, the most common form of dividend policy is one that aims to pay at least the same amount year after year, regardless of the company's performance that year. I'll call this the "consistent" dividend policy.

In such a system, a dividend increase is typically seen as a positive thing -- a sign that the company expects profitability to improve in coming years. Conversely, a dividend cut is usually a negative -- a sign that the company has run into trouble and needs to shore up cash.

Indeed, a number of companies have run into trouble desperately trying to maintain the historical dividend level -- borrowing, selling assets, etc. -- when the logical thing to do would have been to reduce the dividend payout until things got better.

An alternative approach is the "flexible" payout policy in which a company establishes that it will pay a certain percentage of earnings or free cash flow each year. The payout amount could fluctuate up and down, but it relieves the company of having to worry about maintaining a certain payout each year.

I see benefits and drawbacks to both approaches. In the end, I think it depends on the nature of the company's business and the precedent that it has set with shareholders.

U.K.-based Rotork, for example, operates in a cyclical industry and smartly implements a flexible dividend policy that incorporates a "core" dividend that grows in line with earnings plus an "additional" dividend in particularly good years. If the company runs into a bad year, the total payout may be lower than the previous year, but shareholders will likely be more accepting of that since the policy has been clearly communicated and consistent.

On the other hand, Procter & Gamble (a stock I own) operates in a more defensive industry and has paid an increasing dividend for 56 years. As such, its shareholders expect a consistent (and rising!) payout each year. A lower dividend would be disastrous signal.

All that said, many large companies with consistent dividend policies also practice flexible distribution policies -- it's just that they substitute buybacks for cash dividends to bridge the gap. In other words, they maintain a consistent dividend policy and adjust to the business climate using buybacks.

As the chart below shows, since 1999 the modified payout (dividends + buybacks) has fluctuated quite a bit, but the median modified payout has been about 82%.

Source: Standard & Poors

U.S. companies are paying out most of their earnings over the business cycle, just not with dividends -- the median dividend payout ratio over the period is 35% with the balance going to buybacks.

If anything, then, investors who prefer a flexible dividend policy should be demanding that companies use a greater percentage of actual dividends in their distribution policies (i.e. a normal + special dividend policy). I think there's a good case for that.

What's your take? Have a suggestion for future posts? Please post your comments below.

Have a great weekend.

Best,

Todd
@toddwenning on Twitter

How to Identify Dividend Prodigal Sons

Dividend Aristocrats...Dividend Achievers...Dividend Champions. We all know what type of companies are on those lists -- companies that have raised their dividends each year without fail for decades. There's certainly a lot to be said for those companies as they've obviously been doing something right and they almost assuredly have solid competitive advantages. In short, they're a passive dividend investor's dream...when they can be purchased for the right price.

The problem is that investor assets have flooded into dividend-focused ETFs that own these type of stocks. For instance, the SPDR S&P US Dividend Aristocrats ETF raised almost $100m days after it launched...in Europe.

As a result of this heightened investor interest in dividend-paying stocks with impeccable track records, the cream-of-the crop stocks may not be great buys right now. Instead, if you're seeking dividend-paying stocks that have a better chance of being undervalued right now, you should also consider looking into dividend-paying stocks that I'll call "prodigal sons". These are stocks that once had sterling dividend track records but fell from grace during the financial crisis by cutting their payouts and are now in the process of rebuilding their dividend reputation.

Hundreds of companies cut their payouts during the financial crisis, but not all of them cut for the same reasons. Some were forced to by regulators (big banks), some levered up and made silly acquisitions at the wrong time, and some simply got caught paying out more than they could afford. The fact that they cut their payouts shouldn't be forgotten, but they shouldn't be written off completely, either. Some of them may be back on the road to redemption.

But how do we begin to separate the Prodigal Sons from the repeat offenders?

First, determine why the company cut its dividend during the financial crisis. Take a look at its financial statements in 2008 and 2009 and read the press release and management comments surrounding the dividend cut announcement. Did the company have the financial resources to continue paying and opportunistically seized the opportunity to reset its payout to a less burdensome level? Did it make some big investments at the wrong time that -- in hindsight -- put the company in a tough spot going into the recession? In some cases, companies should be let off the hook a bit for making the right investments at the wrong time.

Who was running the company when the cuts were announced? Is it the same team today? If it's the same team, look to see if they've learned their lesson -- look for cost cuts, an improved balance sheet, a more focused growth strategy, better returns on capital and equity, and renewed dividend hikes since the nadir. If the team has changed, what is their strategy and how does the dividend fit into it?

Has the company explicitly addressed the future of its dividend? If the company has realigned its dividend policy to be more sustainable (a lower payout ratio/higher cover), that's a positive sign. A company that's hiked its dividend each year since the cut is another encouraging sign. Look for management's comments on the dividend in conference call transcripts and in annual reports. Companies often address their priorities for free cash flow in conference calls or investor presentations -- is the dividend one of the top priorities?

What was the company's dividend track record prior to the cut? A company that increased its payout for 15 years prior to the cut, for instance, likely means that the dividend is part of the corporate culture and management might be eager to regain its reputation as a steady payer.

All this is to say that some of the best longer-term dividend ideas right now might be found in the group of Prodigal Sons. They should be approached with caution and they'll take more research effort, but the payoffs may be worth it.

Best,

Todd