Until the last few days, the S&P 500 had gone nowhere since mid-February as investors started to wonder how much farther the bull can run.
Fears over geopolitical issues, weakening expectations for earnings and the economy, and doubts on tax reform have all put investors on edge. The CBOE Volatility Index (INDEX:CBOE) VIX volatility index, also known as the “Fear Gauge,” jumped 29% to 15.9 over the first two weeks of April to reach its highest point this year.
A total of 527 companies cut their dividend payments at the height of the financial crisis in 2009 and only the most stalwart dividend-payers survived.
Even bellwether names like General Electric Company (NYSE:GE), Dow Chemical Co (NYSE:DOW), and JPMorgan Chase & Co. (NYSE:JPM) cut their payments to investors. Protecting your portfolio from falling stock prices and dividend cuts today means finding companies with sustainable dividends from strong cash flows and a best-of-breed brand.
When looking for sustainable dividend stocks, I use four fundamental factors to find the companies with the commitment and cash flow to keep putting money in my pocket.
Seeking Sustainable Dividends Against Market Stress
First-quarter earnings are slowly starting to come in and the results are a mixed bag. The S&P 500 closed flat last week as investors started to question high valuations. The bears may finally get their market correction if companies can’t beat expectations and provide positive guidance for the rest of the year.
On the economic side, Morningstar‘s chief economist Bob Johnson believes the first quarter is set to disappoint and that the rest of the year could face hurdles. Retail sales and industrial production for March were a surprise disappointment and showed the economy may be weakening into the second quarter.
The GDP Now estimate of economic growth by the Atlanta Fed started the year at 2.3% before hitting a high of 2.5% in February, but is now estimating growth of just 0.5% for the first quarter.
Against the potential for a correction in the stock market or worse, investors need to start thinking about sustainability in the dividend payments for their picks. Finding companies with sustainable dividends comes down to a handful of fundamental factors such as cash flow, debt coverage, the payout ratio, and management’s commitment to the dividend.
First, I look for companies with at least three consecutive years of increasing cash flow from operations. Companies can raise cash from financing or by selling long-term investments but that’s not a sustainable source of cash. I want to see strong cash generation directly from the business.
Runaway debt can crush a dividend faster than anything, especially in industries where the growth model is to acquire other companies and run up huge long-term liabilities. Watch the EBITDA-to-interest coverage ratio closely to make sure your dividend-payer is making more than enough money to service its debt obligations.
I want to know that management is committed to returning cash to shareholders and there’s no better way to measure this than the 5-year dividend growth rate. On strong economic growth over the last five years, I want to see companies increasing their dividends by 10% or more on an annualized basis.
Finally, if a company gets into trouble and income drops significantly, the dividend could be the first to go.
Watch for companies that pay out less than half their income in dividends to make sure your dividend picks have a sizeable financial cushion.