Are Your Stock Dividends Safe?

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Are Your Stock Dividends Safe?
by John Wightkin, Director of Equity Research Applications, Schwab Center for Financial Research
April 21, 2009

Reprinted from the April 2009 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

A record number of companies have slashed dividends in order to save cash and survive a worst-case economic and financial scenario.
Our research has uncovered a simple strategy that may help you find safer dividend-paying stocks.
Stocks with higher return on equity have provided two benefits historically— more reliable dividends and greater likelihood of outperformance.

What do General Electric, Wells Fargo Bank, Alcoa, Dow Chemical, JPMorgan Chase, Motorola and Pfizer all have in common? It’s not just that they’re blue chip stocks—it’s that they’ve all recently cut their stock dividends. In fact, GE cut its dividend for the first time in 71 years, and Dow Chemical for the first time since 1912.

Unprecedented dividend cuts
This economic downturn has taken no prisoners, punishing most stocks in its path. A record number of companies have slashed dividends in order to save cash and survive a worst-case economic and financial scenario. As of early March, companies comprising the S&P 500® Index had cut more than $40 billion from their collective dividend stream—as much as all the companies in the S&P 500 trimmed in all of 2008, and already a quarterly record.

S&P Senior Analyst Howard Silverblatt estimates that S&P dividends will fall 23% this year¹ (which would be the worst decline since 1928), and our research agrees. The chart below shows the number of stocks that have cut their dividends since 1990, based on a rolling 12-month basis. Clearly, dividend cuts have become far more common recently.

Why dividends matter
Why care about dividends or dividend cuts? Three primary reasons:

Current income: Dividends provide current income to investors, and for many, these payments finance a large portion of their living expenses. A cut in dividends could impact their standard of living if they had to rely on less dividend income going forward.
Dividend changes must matter, fundamentally: Changes in dividends can signal management’s confidence in earnings improvements, which should, therefore, affect the stock price. For more on this topic, see Greg Forsythe’s article “Dividends: Myths and Realities.”
Dividends contribute to a stock’s total return: Reinvested payouts have accounted for the major portion of equity outperformance over the long run. According to Credit Suisse Global Investment Returns Yearbook 2009, U.S. stocks returned, on average, about 5% in real terms each year since 1900; without dividend reinvestment, the real annual return was only 1.7%.

Given these facts, should you simply avoid dividend-paying stocks? We think not. Instead, we suggest you try to become smarter in buying dividend-paying stocks. By comparing characteristics of companies cutting dividends to those maintaining or raising theirs, our research has uncovered a simple strategy that may help you find safer dividend-paying stocks.

One way to avoid companies likely to reduce dividends
The issue in dividend-oriented investing is how to avoid stocks of companies most likely to reduce dividends. To tackle this issue, we examined characteristics of dividend-paying stocks within the top 3,200 stocks by market capitalization, from 1990 to the present.

The characteristics we studied related to companies’ abilities to continue supporting current payout rates—growth rates, coverage ratios (how easily a company can pay interest on outstanding debt) and profitability.

We examined several factors, including payout ratio (the fraction of net income a firm pays in stock dividends), level and change in the debt-to-equity ratio (leverage), return on equity (ROE), and five-year historical sales growth.

We found that one of the more promising factors was ROE, which reveals how much profit a company has earned compared to shareholder equity found on the balance sheet. A firm with high ROE is more likely to be able to generate income in excess of expenses and, thus, support its dividend.

To examine ROE’s ability to predict future dividend changes, we calculated each dividend-paying stock’s trailing 12-month ROE at the end of each month from 1990 to the present. We also calculated each stock’s subsequent 12-month change in dividends at the end of each month, and used this change number to split our dividend-paying universe into three groups: those that cut dividends, those that raised them and stocks with no change.

Next, we examined the success of ROE in identifying safer dividend payers. We found that stocks in the lowest 20% of ROE were twice as likely, on average, to cut dividends as the other 80% over the subsequent 12 months, as you can see in the chart below.

We also discovered that stocks with higher ROEs experienced a greater number of dividend increases over time. Stocks in the top 20% of ROE increased dividends, on average, more than 60% of the time during the subsequent 12 months, as you can see in the chart below. So historically, investors could have minimized their risk of experiencing a dividend cut by focusing on dividend payers with higher ROE.

As an added benefit, our research also showed that companies with strong ROE saw improved returns within a dividend-paying universe. As you can see below, the top 40% of stocks (ranked by ROE) outperformed the dividend-paying universe on a 12-month average by up to 0.80%.

So, based on this research, we found that choosing stocks with higher ROEs among dividend-paying stocks provided investors two benefits historically—more reliable dividends and stocks that are more likely to outperform.

An additional screen has enhanced this strategy
Armed with these insights, let’s now look at an enhancement to this simple strategy—using it in conjunction with Schwab Equity Ratings®. Our simulated research results found that stocks with “A” or “B” Schwab Equity Ratings, chosen from dividend-paying stocks with the highest ROEs, had outperformed, on average, the dividend-paying universe by almost 7% per 12-month holding period.

Compared to using just the simple ROE strategy described earlier, adding Schwab Equity Ratings to the screening process improved performance by close to 6%.

To try to employ this strategy based on our research, clients can use Schwab’s Stock Screener to find stocks matching the criteria described above, by logging in to Schwab.com and clicking on Research > Stocks. There are several links to the Stock Screener on the Stocks page.

Once there, go to the Choose Criteria box and select these three:

Basic Criteria: Dividend Yield greater than zero (click Select All and then deselect None).
Analyst Ratings: Select Schwab Equity Ratings “A” and “B.”
Financial Strength: Return on Equity > Range > Top 20% of the market (type “20” into the box once you’ve chosen “Highest x% of the Market” in the drop-down box).

Now, perhaps more than ever, it’s nice to have confidence that your stock will keep paying dividends!

Important Disclosures

1. The Wall Street Journal, February 28, 2009, “GE Joins Parade of Deep Dividend Cuts.”

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy.

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab’s outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. They do not take into account individual financial, investment or other objectives. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio.

Results from tests using Schwab Equity Ratings are based on use of historical model performance results that have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual investment performance or trading. No representation is being made that any investor will or is likely to achieve profits or losses similar to those shown. Past performance is no guarantee of future results.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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