Dividend investing is a means of building wealth over a long period of time with reduced risk. Many brokers offer fee-free purchases and reinvestments and the ability to reinvest fractional shares. Dividend investing is for the long term buy-and-hold type investor who wants to sleep at night while their investments steadily build.
Articles from The Prudent Investor
Dividend Investing Strategies – High Dividend Stocks
The high dividend stock strategy is like many other strategies in that it appears to be straightforward but contains some hidden risks. If one is to adopt this strategy, then it must be selected with an understanding and a plan. Otherwise, it just becomes just another shiny object one reaches for but never seems to catch. This article offers an understanding of the inherent problems with the strategy and seeks to find ways to overcome them.
The power of dividend investing is based upon the reduction of risk, which leads to the preservation of capital. By deciding not to chase fantasy returns, one can move forward in a world where others move their feet without going much anywhere.
"Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else—if you run very fast for a long time, as we've been doing."
"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"
Lewis Carroll - Through the Looking-Glass and What Alice Found There, Chapter 2
It appears to be a contradiction to both to mitigate and increase risk, though that is what I have done for a long time with my InvestMete Strategy. If one understands the risks inherent with a strategy and has a plan to deal with them, then a dividend investing strategy can be moved to the next level of returns.
The Inherent Risks
The dividend yield is the percentage of the share price that is returned to the shareholder. The higher the yield, the more the shareholder receives. One might think that the strategy should be to seek out high dividend stocks so that they receive the highest dividends possible. Were that the end of the story, this would also be the end of the article.
Hartford Mutual Funds found that "stocks offering the highest level of dividend payouts have not performed as well as those that pay high, but not the very highest, levels of dividends.” Wellington Management divided companies into five groups based upon dividend payout.
The number above each of the five groups indicates the percentage of time the group outperformed the S&P 500 Index during the study’s time period. High dividend companies did better than low dividend companies, but the highest dividend yielders were not the best – the second-highest group was the best. Chasing those with the biggest promises did not deliver as well as those who offer slightly less.
Additionally, high risk does not always equate with high reward, as noted in Alpha and Beta. In 1972 Merton Miller and Myron Scholes showed that high beta stocks underperformed low beta stocks. Simply because one decides to take on an additional set of risks, they are not necessarily rewarded for their efforts.
This is a real problem. One who blindly jumps into high dividend companies without regard to understanding these facts and without a plan is starting at a disadvantage and may have to run as fast as they can to stay in place.
How this could happen is clear. Unlike Treasury bonds or a savings account, dividends are not guaranteed. The company can offer an enticing dividend one day, then make the decision not to pay that it, or pay a smaller amount a subsequent day.
In the article Learning from Dividend Reductions I talked about Codorus Valley Bancorp’s decision to cut their dividend by 37.5% after having raised it each of the past nine years. The pandemic apparently reduced their earnings to the point where they felt that it was in the best interest of the company to offer a smaller percentage of their profits to their shareholders.
A high dividend yield can be a warning sign that may signal a problem. If company XYZ is valued at $100 and offers a 3% dividend yield, and, for whatever reason, its share price drops to $50, the dividend yield doubles to 6%. That would be an attractive yield, but it would be required that one understand why the price dropped before making a purchase decision.
Making a Plan
What is a High Dividend Stock?
Before we make a plan, we need to figure out exactly what defines a company as having a high dividend. There is no actual number that can be used for this. Part of the reason is that the average dividend yield of the market is not consistent. At the end of 2019, the average dividend yield for the S&P 500 was 1.83%. If one were to double that (3.66%) then that would equal the average dividend yield at the end of 1987. Double that again, and it is less than the average at the end of 1950.
For our purposes, I will suggest that a high dividend company offers a dividend yield of 50% higher than the average. Of course, a reasonable follow-up question is, "the average of what?" I will come to that in just a moment.
Looking at the Payout Ratio
The payout ratio defines the cost of the dividend to the company. The payout ratio is the percentage of the profits that are returned to the shareholders. Think of it as a discretionary line item in your budget. While you cannot get away from the mortgage or rent and have to pay the electric bill each month, the money allotted to purchase the expensive coffee might need to be reduced when other expenses eat into your budget.
In the case of the aforementioned Codorus Valley Bancorp, the company had traditionally set aside about a third of the profits for dividends. When their profits declined, the amount scheduled to go to their shareholders increased as a percentage of their profits to the point where they were no longer comfortable offering the dividend, so it became a casualty.
A payout ratio that approaches 100% means that almost all of the profits will go to the owners, without leaving a sufficient amount to cover things that the company requires. Although some companies have allowed this percentage to approach and even exceed 100%, this is not something that any company can maintain for long.
Considering the History
A company's history offers insight into how the company is run and how important it considers the dividend to be. The Dividend Yield and Stock Price Connection explains the connection between stock price and dividend yield, so it is in the interest of the company to maintain and increase the dividend regularly.
The best source for finding companies with a long history of increasing dividends can be found in the Dividend Champions spreadsheet. Companies that have increased their dividend for at least five, ten and twenty-five years are listed in separate worksheets, along with information that can help with one’s due diligence.
The list of Dividend Champions, which have provided their increases over the longest period of time, rarely cut their dividend. It does happen. In the 2008-2009 period, when we experienced the Great Recession, 30 of these companies cut their dividends. It should be noted that only one of these actually suspended their dividend, and more than half of them have increased their dividend over at least the past five years.
During the pandemic, six companies cut their dividends. As I noted in Safety and the Dividend Champions, my opinion is that one company (Calvin B. Taylor Bankshares) should not be included in that list.
Outside of these two unusual events, only four Dividend Champions have reduced their dividends over the past dozen years, and one of these cut following a sale, so it depends upon how one wishes to define "Dividend Champion" as to whether or not it should be included. The bottom line is that Dividend Champions are as safe as one can get when it comes to staying away from a dividend cut.
Putting It Together
Seeking companies with a long dividend history, a reasonable payout ratio, and high dividend ratios are the primary components of the High Dividend Strategy. To begin the screening process, we should use the Dividend Champions as a starting point, as they have already been shown to have a very successful and long career at maintaining and increasing their dividend.
The average dividend yield of the 140+ Dividend Champion companies is 2.93%, so we use the spreadsheet to identify companies that offer dividend yields that are 50% higher than the average, or 4.4%. 21 companies offer such dividend yields.
It is scary to see that nine of these companies have dividend payout ratios over 100%. Nevertheless, this group of companies sees a continuing dividend as exceptionally important to their business model. ExxonMobil and Walgreens are actually over 200%. This indicates that these companies will need to go into debt to pay their dividend, which is something that can happen, but if done too long, can burden a company with debt.
Some companies show "n/a" in the EPS% Payout column, which is where we find the payout ratio. I asked Justin about that, and he told me that this was probably because the company reported negative TTM GAAP earnings, which is used to calculate the payout ratio. You can enter “Chevron payout ratio” to get this information for the few companies where this information is missing.
Nine companies show payout ratios under 75%, so that is a good place to start. Blindly selecting a company from this group can lead one into danger, so this is where one looks at the business model, the company history, and meaningful financial metrics that allow one to make an informed decision.
Despite finding a proper company for purchase, it is important to ensure that the company fits one's portfolio. Of the nine companies that pass the screen suggested above, seven are in the Financial sector. One does not want to place too much weight on one sector. After all, if one were to load up on financial stocks followed by another Great Recession, the portfolio would be subject to an overweighting of bad news.
If no acceptable companies are to be found within the Dividend Champions, then Dividend Contenders offer a listing of companies that have increased their dividend over the past decade. This timeline does not include the Great Recession, which means that company history during that time needs to be researched. The example of Codorus Valley Bancorp would have been instructive to understand how the company reacted under those circumstances.
The High Dividend Strategy can help charge one’s dividend portfolio if the risks are understood, and a plan is formulated to deal with those risks.
Future Dividend Champions – Enbridge
If you are from Canada then you are familiar with this large company. If you are not from Canada then you will become familiar with seeing it in the list of Dividend Champions. Simply looking at this company’s numbers can be deceiving as to whether or not it should be included in your portfolio, so we will investigate the aspect of those numbers that normally remove Enbridge’s ability to pass many screens for safe dividend companies.
If you have participated in the Dividend Investing for Canadian Investors forum, then you know that Enbridge is a company that has been referenced many times. It is probably the most requested company in the Stock Exchange section, with over 1,700 mentions.
Based in Calgary, Alberta, Enbridge (NYSE:ENB, TSE:ENB.TO) is an energy generation, distribution, and transportation company in the U.S. and Canada. It operates the longest crude oil and liquid hydrocarbons transportation system in North America. It is also Canada's largest natural gas distribution company, which also generates renewable and alternative energy.
Chart courtesy of Stock Rover
The energy sector has sensitivities to the business cycle, which is currently not performing well due to the pandemic. Although the shutdowns feel like they will last forever, certainly that is not the case, so this may be a good time to consider looking at dominant players of the sector while their prices are low.
Enbridge shows its dominance through its infrastructure. A quarter of all crude oil in North America flows through its pipelines, as well as 20% of the natural gas that comes into the United States. Their cash flows are highly predictable, as nearly all of its EBITA is regulated, cost-of-service, or contracted. Additionally, nearly all of their customers are investment-grade companies.
The company has spent almost $8 billion over the past two decades in renewable energy and power transmission projects, which is a drop in the bucket compared to the whole of the company. Like many other energy companies, however, Enbridge sees oil and gas going away in the distant future and is working to find an impact in alternative energy sources
Chart courtesy of Stock Rover
Enbridge’s share price has been unimpressive over the past five years, actually sitting about 13% lower over that period of time. During the same timeframe, the S&P 500 gained almost 75%. This is not a growth company to purchase in the hopes that the market pushes it to new highs, it is a company to purchase primarily for the dividend.
And oh, what a dividend it is.
Enbridge’s current dividend yield clocks in over 8.5%, which is monstrous. Were the company not on the cusp of being one quarterly dividend offering away from 25 consecutive years of dividend increases, then such a high dividend would have red flags waving in front of it. A yield of this sort normally will not make it through many of my screens because the yield is in the “if it looks too good to be true…” category.
However, its history demands that we at least give it a serious look.
Chart courtesy Stock Rover Research Reports
There is no question that Enbridge's dividend growth is impressive. Their 10-year growth rate is an impressive 14.4%. This is not a company that offers a token dividend increase to maintain a consecutive streak, as has been the case with too many companies I have examined. Each increase is meaningful and aggressive.
The company’s sentiment is that they take their dividend very seriously. Their website touts, “We have a consistent track record of delivering annual dividend increases, and our continuing goal is to deliver superior shareholder returns through capital appreciation and dividends.”
From Enbridge’s website
They follow this by noting that they have paid dividends for over 65 years, and "our dividend growth has not come at the expense of our financial strength as our dividend payout remained very strong in 2019, at approximately 65 percent of our Distributable Cash Flow (DCF).”
Keep this quote in mind, as it is key to understanding an essential part of the consideration process of this company – whether or not Enbridge has the means to continue offering their dividend well into the future. After all, a great dividend that is not there for us in the future is not helpful to our financial wellbeing.
According to MarketBeat, their payout ratio currently lies at 329% of trailing 12 months of earnings. This is the point where I normally walk away and look for other investing opportunities. I typically seek out companies with a payout ratio of around 40-60%. This range tells me that the company feels that it is important to give a significant portion of the profits back to its shareholders and that the amount is affordable to the company.
Even cut in half, their payout ratio would still make anyone uncomfortable. Looking into their payout ratio history shows that this number has always been high.
I will ignore the 2015 amount, as it is not necessary to understand what happened that year, but it is not. The high payout ratio has been a staple for eight of the past nine years. Normally, this would not be a sustainable situation, so something must be going on.
The “something going on” is linked to the wording in the paragraph above I flagged to be remembered, which referenced, “65 percent of our Distributable Cash Flow (DCF)”. That is the key point to be understood in this article.
Pipeline companies like Enbridge are not well analyzed by just looking at GAAP earnings because of their high depreciation/amortization charges.
For such companies we should be comparing the dividend amount to the distributed cash flow, which takes depreciation and capital maintenance into consideration, as opposed to the earnings.
DCF is not a GAAP term, so there is no codified definition for the term. However, the generally accepted meaning is:
DCF = Net Income + Depreciation and Amortization – Capital maintenance
Depreciation allows the cost of large ticket items to be spread out over the course of its useful life. Net income is a real thing, as is Capital maintenance. However, Depreciation is an accounting item that does not indicate cash leaving the business, so it is not an actual cash expense.
Increasing the denominator in the formula (Total Dividends / Distributable Cash Flow) dramatically decreases the percentage. While this may initially sound like an accounting trick to make something appear artificially better, it is actually a better and more complete means of understanding the pipeline company’s ability to retain its dividend.
This is the reason that Enbridge has appeared to be somehow sustaining something that would appear to be unsustainable. For most companies we examine the payout ratio to ensure that the company has the ability to sustain the dividend. However, this is a case where using distributable cash flow as a metric makes more sense, so the 65% they reference falls close to the 40-60% I noted as my general target.
Enbridge is not a company without risk. Their ability to execute capital programs on time and within their budget has been challenging, especially with large projects. This has shown itself in the form of increasing debt.
The increasing debt, however, has been offset by increasing equity, and Enbridge has moved significantly toward the lower end of their debt-to-EBITA ratio target. This has given them positive ratings with major credit agencies, resulting in favorable interest rates.
Enbridge has a long history of dividend increases. Their dividend yield is very high, but that appears to be sustainable. The company is large and a leader in its industry. On the cusp of joining the elite Dividend Champions, it is certainly a company to consider if seeking an energy company for one’s portfolio.
Disclosure: I started a position in Enbridge in October and will build it over time with numerous small purchases.