Between 2007 and 2009, approximately 34% of American stocks that pay dividends quarterly cut their payout at some point during the recession. The part I find worthy of examination? The fact that 56% of stocks that paid monthly dividends ended up cutting their payout during the recession. The same corporations that suggested you should invest in them for their cash flows had a disproportionately higher likelihood of slashing their payouts than the regular American companies that made no special promises about the future of their dividends.
How should we analyze this?
My view is that many companies have opportunistically recognized that the ability for savers to use their funds to create a meaningful monthly cash flow has been severely compromised in the past decade. There are no savings accounts or U.S. bond investments paying out 5% anymore. Adjusting to the circumstances, many of these investors took up the purchase of things like real estate investment trusts or master limited partnerships. Five years ago, no one outside the most sophisticated investor class had heard of these things, and now mom and pop investors found themselves rushing in with 10% to 15% of their net wealth to try and improve their household’s monthly passive income cash flows.
This created fertile soil for company executives to develop a marketing angle to boost the price of their stock above what a sober analysis of the underlying assets would reveal. How many people in the investor community would pay more to receive ten cents per share each month rather than a lump-sum $1.20 payout each year? Exactly. And therein lay the opportunity.
Sometimes, this just meant getting investors to pay more for an ownership stake in an asset than should be warranted. The theory is that you get investors to bid up the price of a stock to 1.3x compared to the price that existed before the switch to monthly dividends. Aside from the usual reason why businesses like rising stock price, it is permits borrowing at rates because any equity-based financing is an advantage for the company because you are diluting the business when it is trading at a price higher than what it is worth. Basically, using the stock to raise capital is the equivalent to giving up $0.70 in value financiers in exchange for each dollar that they give you in return.
It is also helpful for debt-based financing because the market capitalization of a business is a factor in determining the interest rates that the business must pay.
I mean, look at this list from Lisa Springer of Street Authority in 2013 that gave examples of the 22 best monthly dividend stocks to buy. Only 6 of those 22 companies are paying out monthly dividends right now at rates that are higher or equal to the amount that they were paying in 2013. It hasn’t even been four years, and over 70% of the monthly dividend payers on the list have already failed. And that was from a self-selecting group that she presumably culled for some type of fundamental characteristics that looked good at the time.
An important side note. Realty Income deserves a pass because it actually has real rental income coming in, has been doing monthly payouts since 1994, and was created with stable cash flows in mind out of a sincere desire to address this corner of the income market. This is different from the latest crop that seek to opportunistically exploit the income investor class while interest rates and alternative income investments are lacking.
Stocks that pay dividends each month deserve criticism because they are often preying on you to bid the price up to shore up their own finances. My own research on those 22 stocks mentioned in the Springer recommendation list led me to observe five things: (1) 17 of those 22 stocks had leverage that was greater than 5x the annual cash flows; (2) 15 of them were borrowing at rates greater than 5% at the time the list was created, which is notable because of how low corporate borrowing was at the time; (3) 14 of them had a share count that was at least 25% higher by 2015 compared to 2013; (4) only 3 of them were paying out dividends each month before it became fashionable in the aftermath of the financial crisis; and (5) only 7 of them have higher stock prices than was the case at the time the article was written, which is remarkable because of the general bull market conditions.
Do me a favor and read that paragraph again because it took me almost two hours to tabulate that data.
I know balance sheet analysis isn’t anyone’s idea of a good time. But when it comes to these monthly stocks, you have to do your homework. Check to see whether the dividends are supported by current earnings. See how much greater the balance sheet debt is compared to the cash flows. Find out the interest rates on the existing debt. Make an educated guess as to whether that debt burden will be refinanced at higher rates. Look to see if there has been meaningful dilution in recent year.
Usually, companies become monthly dividend stocks because they “resort to it” rather than have a strong desire to connect with income investors. These payouts are very ephemeral. They might pay the bills for a month or two, or maybe even a year or two. But they can’t withstand recessions. Heck, as the last few years have shown, they can’t even withstand the good times. You’d be much better off stocking up on shares of Johnson & Johnson, ExxonMobil, and Coca-Cola and integrating their quarterly payouts into your budget. Why? Because when the business is built to last, so will the dividend payments.
Originally posted 2017-01-11 06:00:38.