Catching the Falling Dividend Knife

The yield on shares of the Energy Select SPDR ETF (NYSE: XLE) have increased to 2.8% from 1.7% this time last year. That puts it over my 2% minimum for dividend stocks but is there more to the surge in dividends than just a higher payout?

The payout on the fund has increased to $1.99 per share over the last four quarters, a strong increase on the $1.69 paid out per share over the four quarters to July 2014. Of course the real story is the decrease in the price of the fund, from $97.41 a share last year to just $71.38 per share currently.

It’s a common trap for dividend investors, rushing in to buy shares of a stock as the dividend increases after a drop in the shares. Too often, the poor fundamentals that led to the share decline leads to a dividend cut to conserve cash.

Worse yet, the share price could keep dropping and completely wipe out any gain from the higher dividend yield.

The market talks of, “trying to catch a falling knife,” when value investors attempt to buy stocks on the way down. Good deals can be had but returns can be cut severely if prices continue to fall.

How do investors take advantage of attractive dividend yields on stocks that have suffered a decline, without getting cut in the process?

Finding Dividend Value without the Value Trap

Investors talk of a ‘classic’ value trap as if there are defined signals that a stock is only going to get cheaper. In truth, most people only realize a stock is a value trap in hindsight. For dividend stocks, apart from the analysis I do to determine if the stock is a good value, I look to a few fundamentals to judge it on its income potential.

The most obvious question you have to ask is whether it is really a dividend stock or not. If the shares were only paying a yield of 1% before the decline in price, then management and the board of directors may not hold cash return to investors as a priority. Look to the average yield on shares over the last few years, especially before the share price decline.

Follow the average payout ratio as well for indications on the priority of cash return. While most company’s will try to preserve their per share dividend as long as possible, it is the payout ratio that will forecast a dividend cut. If a company is only willing to pay out 20% of earnings as dividends, leaving the rest for investment back into operations, then a significant drop in earnings (forcing the payout ratio up) may lead to a cut in payout to bring the ratio back down.

Ultimately, cash flows are what matters most for dividend investors. It is out of cash flow that dividends are paid, not earnings. If cash flow from operations decreases too quickly, management may decide to cut the dividend in order to protect the company’s cash position.

A company may have negative earnings for years and still be able to sustain a high dividend. Companies in the mining and energy space have seen their earnings drop quickly but book hundreds of millions in depreciation each year. Since depreciation is a non-cash charge, it reduces earnings but not cash flow.

You will need to watch the Statement of Cash Flows for the health of the company’s payout. Non-cash items like depreciation and some changes in working capital may decrease earnings but not cash. I like to follow the trend in cash flow over several years. Lower cash flow from operations over one or two years may not be an issue but warning bells start to ring if cash generation hasn’t recovered after two years.

Free cash flow is the amount of cash flow from operations minus capital investments the company makes do sustain or grow operations. Theoretically, this is the amount the company can pay out to investors and still maintain operations. Watch for quickly decreasing capital investment as a sign that management is frantically conserving cash. If the business doesn’t turn around, the dividend may be the next to be cut.

Looking at a dividend stock in this way, you can at least get an idea of its potential to continue paying out a respectable cash return. Combine it with some basic analysis on the company’s value and you can sleep well on the fact that your investment will yield a good return over the long-run, even if shares lose some additional value in the short-term. If you don’t have the luxury of time, stick with more stable dividend stocks.

The one caveat I would include is to remember basic investment allocation and your own risk tolerance. If you are close to retirement or a spending event where you will need to live on your investments, do not take the risk of investing in a stock on its way down. If the stock continues to fall, you may need a few years for fundamentals to come through and for the shares to rebound.


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