How to identify a sustainable dividend

For the income-focussed equity investor, there are few things that strike fear into the heart more than a dividend cut. The capital losses alone can destroy years of income, and that’s before you even consider the reduced dividend stream. Telstra has fallen nearly 30% since announcing its dividend cut in August last year; assuming no further cuts, this is equal to five years of dividends at the reduced payout. So how can investors help avoid these painful situations? We asked three leading equity income experts what they look for when assessing the sustainability of a dividend. Responses come from Aaron Binstead, Lazard Australian Equity Team; Hugh Dive, Atlas Funds; and Neil Margolis, Merlon Capital Partners.

Dividend cuts are an unfortunate reality

Aaron Binsted, Portfolio Manager/Analyst, Lazard Australian Equity Team

Assessing the sustainability of dividends isn’t easy. When we quantified the impact of dividend cuts over a multi-year period we found that 15% of ASX200 stocks cut their dividends and that the average size of the cut was 35% compared to consensus expectations. Dividend cuts are an unavoidable reality when investing in equities. That said, we do think you can minimise this cost to returns through active fundamental based management. Over the same period the Lazard Australian Diversified Income Fund managed to halve this dividend cut drag on returns.

In terms of specific indicators, the most important point to make here is that you can’t judge dividend sustainability by a set of fixed ratios. Different companies require different ratios and companies themselves change over time.

You really need continual, fundamental bottom up assessment to determine dividend sustainability.

If I had to name three ratios as a starting point they would be: trend in operating earnings, the level of gearing and cash flow generation and coverage.

Clearly, if a company is not growing earnings it will be very difficult to maintain or grow dividends into the future.

Regarding gearing, debt holders get paid before shareholders, so you need to make sure there is enough cash for both groups of financiers to get paid.

And lastly, cash flow and cash coverage touch on both the level of cash backing a company’s earnings and the choices a company is making in terms of uses for that cash flow. Two items to focus on here are capital expenditure and acquisitions. Feeding the balance sheet can leave less for dividends. 

Of pennies and steamrollers

Hugh Dive, Chief Investment Officer, Atlas Funds Management

We look at the question of dividend sustainability very closely when constructing the Concentrated Australian Equity Portfolio. One of the main factors in building the portfolio is identifying companies that can deliver consistent distributions that are growing ahead of inflation, whilst actively avoiding companies with distribution risk. As we have seen with Telstra over the past few years,

high current distributions do not compensate investors for the capital fall that occurs when the dividend is cut.

In investing terms, buying companies that have a chance of cutting their dividend this is a bit like picking up pennies in front of a moving steamroller, you may snatch a few coins but eventually your arm will get crushed by the roller!

Three key indicators that we look at are;

The dividend payout ratio divides the dividend by the earnings per share. When a company paying out 90 to 100% of its earnings faces a small change in profitability, it will have to cut its dividend, whereas a company with a payout ratio of say 50% not only can handle the inevitable changes in market conditions, but also has the scope to increase dividends without an increase in company profits.

With some companies such as Transurban, for accounting reasons, you will want to use free cash flow instead of earnings, which are impacted by accounting items such as a high depreciation charge.

Leverage is another factor that we look at when evaluating whether a company can sustain and grow their dividend. Here we are looking both at standard ratios such as debt to equity and interest coverage; as well as when the debt is due.  Whilst leverage magnifies returns to equity (and thus dividends) when times are good, when conditions deteriorate and the heavily indebted company's bankers come hammering at the door, cutting the dividend is inevitably the first action. For example, in 2015 rising debt levels forced grocery wholesaler Metcash to cancel the dividend for a number of years in an effort to reduce gearing. 

Finally, we look at earnings and cash flow growth, as if a company is not growing earnings it is obviously not in a position to increase dividends and this may be the sign that the company operates in a stagnant or declining industry.  Ultimately investors buy shares in a company in the anticipation of receiving a stream of earnings that will grow ahead of inflation. If dividends are static, then the real value declines annually.

It’s all about the cash flows

Neil Margolis, Lead Portfolio Manager, Merlon Capital Partners 

At Merlon, we focus on sustainable free cash flow as the key driver of long-term value and sustainable dividends. This can be very different to current cash-flow, which may be inflated or depressed by transient factors, or current dividends, which are also a function board payout ratio policy. With National Australia Bank, for example, we estimate sustainable free cash flow or dividends to be $1.45 per share instead of the $1.98 currently being paid.

The first consideration in determining sustainability is the sensitivity of a company’s cash-flows to macro-economic factors outside its control, such as interest rates or commodity prices. Our focus is on mid-cycle cash-flows for macro-sensitive companies.

The next consideration is industry structure.

Cash-flows and dividends are more sustainable in concentrated industries with high barriers to entry and fragmented suppliers and customers.

An attractive industry structure is able to raise prices to offset higher input costs, such as mortgage banks or general insurers.

After this, we focus on competitive advantage within the industry – whether a company has a cost advantage, differentiated product or loyal and sticky customers.

The final qualitative consideration is management as we rely on the cash-flows being used for dividends or debt reduction, as opposed to poor investment decisions.  We focus on governance and remuneration structures, as well as management’s track record in capital allocation.