Dividend Investing is a popular investing strategy based on a simple principle: the payment of regular distributions to shareholders. This investing technique is interesting because it allows the investor to benefit from both a gain in capital due to good financial performance and dividend payments that make the wait more comfortable. Unfortunately, I’ve seen too many investors keep losing dividend stocks simply because they are receiving these distributions.
The dividend payout is certainly a good argument to hold a stock during a storm on the stock market. However, this doesn’t mean that all dividend stocks are good and should be kept forever. This is why investors must constantly look-up each stock fundamental to assess if the stock will grow and if the dividend will follow.
#1 High Dividend Payout Ratio
The main reason why you would buy a dividend stock is to benefit from dividend growth over time. Receiving a 3% dividend payout on your investment is good, but if this 3% can grow by 5% each year, you will be receiving 6% in 14 years. If you start investing early, you could probably end-up with a safe portfolio paying a 6%-10% dividend yield at retirement.
The key to see such dividend growth is definitely to keep a low dividend payout ratio. When the dividend payout ratio goes higher than 75%, chances are that the company is less likely to increase it dividends in the future. Therefore, there are 2 possibilities to this scenario;
a) The company will keep the same dividend for a few years.
b) The company may cut its dividend if the payout ratio becomes unsustainable (over 100%)
Please keep in mind that when a company shows a dividend payout over 100%, it is because the company is financing a part of the dividend. This is definitely not a good sign for any investor. When I buy a stock, I usually target a maximum payout ratio of 75% with a pre
ference for stocks under 60%. I sometimes pick a stock with a higher payout ratio when I believe that the company is growing and will decrease its ratio in the upcoming years.
If you have any dividend stocks with a high payout ratio, I would seriously consider selling them. You can read a great article explaining how to calculate the dividend payout ratio, here.
#2 No Dividend Increase
As mentioned in point #1, the core of a dividend investing strategy resides in dividend growth. If the management team doesn’t control its cash flow efficiently, they might have to keep their dividend payouts at the same level for a long period.
A dividend that is not being increased on a yearly basis or every two years also hides other problems. It is actually a sign that the company is not generating enough to grow both its revenues and its dividend. At first, it won’t affect the value of your stock. But over time, investors will notice the company inability to increase its free cash flow.
If a company doesn’t increase its dividend over time, inflation will slowly eat-up your dividend yield. Since a dividend stock that doesn’t increase its payout will lose interest from investors, chances are that you won’t be able to recoup your investment return with big capital gains.
Therefore, if a company doesn’t increase its dividend for more than two years, it’s definitely a sign that you should look into its financial statements and consider selling it.
#3 Earnings Per Share (EPS) Decrease
Over each quarter, you should also take a look at EPS. Since dividends are paid from net earnings, the EPS is crucial for the dividend payment. In order to hope for constant dividend increases, you definitely need a growing EPS.
This is why you should look into your investments after each quarter to make sure that EPS are stable or increasing. Upon a bad financial result, there is no reason to panic. You simply have to determine what had caused the EPS decrease. It could be several things:
a) A special loss due to the sale of a division, end of business activities or restructure
b) A provision for a lawsuit, account receivables
c) An uncontrollable event (the Tsunami inJapanfor example)
d) Exceptional cost related to a merger & acquisition, R&D, launch of a new product, etc.
As you can see, most of the reasons mentioned above will not continuously affect the EPS and should not become a reason to sell. It’s important to identify the reason why the EPS is decreasing and then, determine if this reason is a new condition of the company’s environment or simply an event that has been taken care of and won’t likely happen again in the following quarters.
#4 Profit Margin Decrease
Similar to the EPS, the profit margin will greatly affect the company’s ability to increase its dividend. Pressure on profit margins usually comes from the overall economic environment or the company’s specific field of operation. Profit margins will be under pressure due to high competition or the arrival of a product substitute.
In the upcoming years, a good example would be the computer industry. With the arrival of powerful smartphones and tablets, desktops and laptops sales might slow down. Many consumers will prefer to use mobile and smaller electronic devices than a big desktop. This is a sign that the computer industry (that has already reached maturity) will be under profit margin pressure. Computer builders will have to decrease their prices to keep their product attractive while investing massively in new technology (smartphones or tablet components) in order to shift their business. This is the kind of challenges companies like Intel (INTC) and Seagate Technology (STX) will face.
When you look at both companies, there is no reason to panic for now. Then again, the pressure on profit margin is only a sell signal but it’s not to be considered as an alarm button either. It’s important to look at the overall picture and the company possibilities to overcome their challenge. In order to continue this example,INTCis currently investing a lot of money and effort to enter in the smartphone and tablet market. As for STX, they are increasing their market shares in cloud computing and looking to develop flash memory (which is believed to be the future of mobile electronic data storage).
#5 Dividend Cut
The ultimate sell signal for a dividend stock is definitely a dividend cut. In fact, if I hold a stock announcing a dividend cut, I will automatically sell it and concentrate on my next trade. The goal of this article is that you follow the first 4 stock sell signals and you never get to sell a losing position after a dividend cut. When the announcement is made, you will rarely have a positive response from the stock market.
On the other hand, predicting a dividend cut could be quite easy (unless the cut is due to an exceptional event). When the company shows a dividend payout ratio increasing, EPS on a downtrend and pressure on the profit margin, you should eventually expect a dividend cut. Keep in mind that this move is used as a last resort for many companies since the management team is very aware of the catastrophic effect this news will have on the stock price.
Many companies cutting their dividend are already in a bad financial position and should have already been sold from your portfolio, unless you are a speculator!
What do You do After theSale?
It’s important that your selling process is completely rational. Don’t sell a stock when you panic or are frustrated by bad news. Take a few days to understand the sell signals you detected and assess the company’s ability to overcome its challenges.
Once you have sold your stock, take your time to make another trade. If you sell at a loss, the temptation of recouping your money quickly is strong. Dividend investors should be looking at a long term investment horizon. It doesn’t matter if you don’t get your money back during the next quarter. What matter is that you have minimized your loss and look to make a positive trade as your next move.
Disclaimer: at the time of writing this article, I hold positions inINTC& STX.