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Understanding Dividend Safety: Key Indicators to Watch

Dividend investing is often seen as a straightforward strategy, but it’s not simply about selecting the stocks with the highest yields. Even companies that have consistently raised their dividends for years can and do reduce payouts. Investing based only on yield can lead to unexpected losses if a company cuts its dividend unexpectedly. To ensure your investments are sound, it’s important to focus on companies that maintain a balance between high yields and sustainable payouts.

Red Flags: Signs of a Potential Dividend Cut

Although no method can fully protect you from a dividend cut, there are key indicators that suggest a dividend might be at risk. Paying attention to these signs can help you make more informed investment decisions and minimize surprises.

1. Payout Ratios

The payout ratio is an important measure for assessing dividend safety. It compares a company's earnings to its dividend payouts. A ratio higher than 100% may indicate that the company is paying out more than it earns, which is not sustainable in the long run. However, dividends aren’t paid purely from earnings but from cash flow, so it's important to also consider the cash dividend payout ratio.

High ratios in either measure should raise concerns, especially if they approach 100%, signaling that the company may not be able to maintain its dividend without cutting it.

Real estate investment trusts (REITs), for example, may have a high payout ratio due to depreciation charges that don't directly affect cash flow. In these cases, the payout ratio might be misleading, but in general, a consistently high payout ratio could be a red flag.

2. Balance Sheet Strength

A company’s balance sheet is crucial in determining whether it can support its dividend during tough times. A company with significant debt might be forced to cut its dividend during a downturn to manage financial stress. Take ExxonMobil, for example, which has a conservative approach to debt management. In times of low oil prices, it can rely on its strong balance sheet to continue paying dividends. On the other hand, companies with higher debt levels, like Eni, may have less flexibility and could be forced to cut dividends during volatile periods.

Additionally, companies that use leverage aggressively, like Kinder Morgan, can face significant pressure during economic downturns. While Kinder Morgan cut its dividend during a tough time, it did so strategically to preserve capital, demonstrating that sometimes reducing dividends is necessary to ensure long-term viability.

3. Interest Expenses

A key indicator of a company’s ability to support its dividend is its ability to cover interest expenses. The times interest earned ratio compares a company's income to its interest expenses; a higher ratio suggests the company can easily cover its interest payments. Companies with low interest coverage are at a higher risk of struggling to maintain dividends, especially during economic slowdowns. For instance, if a company’s times interest earned falls below 1.5, it’s an indication that the company might face challenges in meeting its debt obligations without reducing its dividend.

General Mills provides an interesting example. While its times interest earned has decreased, the company is using its debt to fuel growth through acquisitions, such as the purchase of Blue Buffalo. Although it is not cutting its dividend, the company has stated that it will focus on debt reduction before considering future dividend increases.

Conclusion: Balancing Risk and Reward

Investors must be cautious when chasing high yields, as they often come with higher risks. Indicators like the payout ratio, balance sheet strength, and interest coverage can help you assess the sustainability of a dividend. When a company has a high payout ratio, substantial debt, and low interest coverage, the risk of a dividend cut is higher. While there is no guaranteed way to predict dividend cuts, these tools can help you make informed decisions and potentially avoid investments that could lead to disappointing returns.

For those considering dividend investments, it’s crucial to focus on companies that can balance growth and financial stability. Monitoring these key indicators can help safeguard your investment portfolio and ensure that you’re not blindsided by unexpected dividend cuts.

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Nothing in this newsletter is financial advice. Always do your own research and think for yourself.