Over the last few years, every dividend investor I knew loved one stock.
For decades, it was a beloved holding within many retirement portfolios because of its defensive cash flows, reliable dividend payments, and relatively high yield.
It sounded like a dividend gem. But everything began to change when its management team decided to change the business model and venture outside its core competency.
And since everyone was buying it, those investors who ignored the warning signs of looming disaster got burned.
Far too often, I’ve seen investors fall prey to herd mentality, making hasty and irrational decisions that are detrimental to their financial health.
Here at Intelligent Income Daily, our disciplined research ignores momentum and emotional trends. Instead, we focus on company fundamentals (their earnings, net income, and cash flows), growth potential, and balance sheet strength. This approach helps us differentiate between the actual dividend gems and the duds.
And today, I’ll show you how to avoid the herd mentality. By paying attention to the metrics I’ll lay out below, you can catch yourself before falling victim to a dividend cut trap.
Too Many Investors Ignored These Warning Signs
The company I talked about above is AT&T.
Until recently, it was on a 36-year dividend streak. It seemed like everywhere I went retirees swore AT&T would never cut its dividend.
And yet, the fundamentals painted a different picture.
- AT&T posted negative year-over-year revenue growth during 11 out of its last 13 quarters.
- In 2019, its free cash flow was above $29 billion. By 2021, that figure fell to $25 billion.
- AT&T’s operating margin has been trending lower for a decade. And in 2021, it hit single digits.
But that wasn’t the only reason I recommended my readers stay away from the stock.
In 2015, AT&T spent approximately $67 billion to acquire DirecTV, the satellite television company.
And then in 2018, it doubled down, spending another $85 billion to acquire Time Warner Media and its crown jewel digital streaming property, HBO.
This was all in an effort to establish itself as a dominant player in the content production industry – an avenue that was a far cry from its telecom business.
But the company failed to produce profits in the highly competitive streaming space.
After its empire-building attempt in the media space, AT&T’s debt load soared up above the $180 billion threshold. And that began to cut into its cash flows.
All of a sudden, this former blue chip had lost its dominant competitive position in the telecommunications space.
AT&T suffered throughout this saga, with its shares falling by 31.3% during the last five years…during a time when the broader market was up by nearly 55%.
In other words, AT&T shares underperformed the S&P 500 by roughly 80%… And to make matters worse, in 2021 AT&T slashed its dividend by 47%.
In short, enormous debt, rising interest rate expenses, and falling free cash flow clearly pointed towards dividend sustainability issues to investors who were willing to look at the numbers objectively.
Focus On Fundamentals to Avoid Falling Over a Cliff
It’s true no equity dividend is ever 100% safe.
However, if you know how to properly vet a dividend’s safety, then you can take significant steps to minimize risk and preserve (and grow) your passive income stream.
If you know what to look for, not only can you largely avoid dividend cuts, but you can own stocks that increase their dividends every year.
So, instead of joining an irrational herd, follow the numbers.
- A rising sales trend is a good place to start because strong sales imply strong demand for products and services.
- Make sure that a company’s cash flows are stable.
- Avoid names that are experiencing margin deterioration.
- Ensure that you’re investing in companies with high, investment grade credit ratings.
- And always make sure that a company’s dividends are covered by earnings (ideally with a wide margin of safety).
Following the fundamentals (instead of the herd) has allowed my passive income stream to grow, year in and year out, regardless of how the broader markets are performing.
That is what allows me to sleep well at night with my investments.
Happy SWAN investing,
Editor, Intelligent Income Daily
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Source: Wide Moat Research