Franceâ€™s new top marginal tax rate is 75 percent. And while most countries wonâ€™t go nearly that high, itâ€™s a pretty safe bet high earners will see their levies rise in coming years in most places. That almost certainly includes the US, no matter who wins the November election.
Nevertheless, this is still a good time to have money, while itâ€™s an extraordinarily bad time to need money. And itâ€™s rarely been more critical for investors to factor that distinction into their security selection.
But it doesnâ€™t change the fact that the US economy is still on the same sluggish growth trajectory itâ€™s been on since the 2008-09 crash, or that Europe has slipped into a high unemployment recession, or that the economies of emerging Asia have slowed markedly over the past year.
Donâ€™t get me wrong.
Iâ€™m certainly no doomsayer.
In fact, my view remains that pundits have grossly exaggerated Chinaâ€™s troubles, Europe will work its way through its current difficulties, and US politicians will prevent a fiscal cliff. But buying into upside momentum on a day like today makes as little sense as succumbing to selling on a day where downside momentum is running rampant.
Either way sets you up for failure. Rather, as far as investors are concerned, itâ€™s all about picking the right dividend-paying companies. And that means staying with those that have money, and generally avoiding those that need it most.
If you want to own stocks for dividends, youâ€™ve got to stick around long enough to collect them. That means essentially buying the business, and holding the stock as long as that business is healthy and growingâ€“and selling if that underlying business weakens.
At their core, companies are only as solid as the people who work there. And as investors, weâ€™re clearly outsiders trying to gain insight into their operations. That means thereâ€™s going to be plenty we donâ€™t know about, even in businesses such as essential services that are relatively transparent.
Any publicly traded company, however, must provide publicly available information. And one area management has to be highly specific about is money.
Some companies do a better job than others in the clarity department. While other firms occasionally engage in wholesale fraud. But the regular financials that companies file each quarter will give you a good idea of whether or a company has money, if you examine them closely enough.
Fortunately, with regulated utility companies, the task is made somewhat easier by the fact that businesses are heavily asset-based, which means theyâ€™re centered around highly tangible things like power plants and power lines. In addition, regulators have oversight over the utility sector, at least by statute. That doesnâ€™t always ensure against fraud, as the collapse of Enron proved in late 2001. But it does add one additional layer of reporting.
Should you trust numbers blindly? Absolutely not. But as you look over your utility stocksâ€™ second-quarter results, here are two to consider:
First is the payout ratio. This is basically the dividend as a percentage of the relevant measure of profits. Logically, the lower the payout ratio, the safer the dividend and the better the odds of a dividend increase.
Itâ€™s tempting just to go to some broad-based data source, such as those provided by major brokerages, to see numbers reported. Unfortunately, these computer-generated payout ratios use a single number to define profits: Earnings per share under Generally Accepted Accounting Principles (GAAP). And for many companies, that number doesnâ€™t represent a true measure of profitability, which means the payout ratio will be misleading.
Thatâ€™s why thereâ€™s no substitute for going to the individual companies themselves to find what the best measure of profits is. Any one-time gains or losses, for example, should be excluded from profits and therefore payout ratio calculations. Some companies, meanwhile, pay dividends from cash flow and try to minimize GAAP earnings per share (EPS).
These include rural telephone companies like Consolidated Communications (NSDQ: CNSL), which reported free cash flow that strongly supported its dividend, despite low GAAP earnings. It also includes master limited partnerships (MLP) like Enterprise Products Partners (NYSE: EPD), which by law is allowed to pass on cash flow to unitholders without paying corporate tax.
Most companies that use an alternative to GAAP EPS will provide their numbers for you. I suggest going one step beyond that. For example, if a company reports earnings that donâ€™t include â€śnon-recurringâ€ť losses, find out what those losses are. Odds are, they are one-time items, but there may be more of the same ahead. Also, if a company reports cash available for distribution as its measure of profits, make sure that tally doesnâ€™t also include cash in the bank, but only whatâ€™s generated by operations.
There are some companies that build cash reserves in bad times to maintain dividends when operating cash flows fall short. One example is power generators with hydroelectric dams, where water flows can vary from season to season. Here, too, itâ€™s safer to stick with companies that cover dividends with current cash flow, rather than reserves that may run out.
As for an overall payout ratio number thatâ€™s â€śsafeâ€ť that really depends on the industry in question. The more regulated a company is, the higher the payout ratio it can sustain. But generally, I like to see utilities have payout ratios no higher than 80 percent and preferably in the neighborhood of 60 percent, as that tends to portend dividend growth. MLPs that own pipelines can go a bit higher, as they tend to pay out higher percentages of cash flow.
The most important thing is for the company to post numbers that keep the payout ratio within managementâ€™s previous guidance. As long as thatâ€™s the case, thereâ€™s nothing to worry about regarding the payout. If thatâ€™s breached, a cut is not guaranteed. But it is time to look for some reassurance.
The second number to consider is the amount of debt coming due between now and the end of 2013. A company with no maturing debt between now and the end of next year can avoid the credit market should conditions tighten in the near term. Those with a large amount of obligations coming due before then may be forced to borrow at extremely high rates, or else take other steps to save cash flow to pare debt, such as dividend cuts.
Having to choose between borrowing at exorbitant rates and cutting dividends has triggered half a dozen payout cuts at European energy and telecom utilities this year and will undoubtedly trigger more. Itâ€™s also prompted a number of dividend-paying energy producers to cut payouts in the wake of falling energy prices.
As with the payout ratio, there is no magic amount of debt that ensures a payout is safe or presages a coming dividend cut. But the operative rule is the less debt coming due the better. That way, your companies will avoid having to borrow at the worst possible time, which is most definitely a prescription for a dividend cut.
– Roger S. Conrad
Source: Investing Daily