Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / How Companies Decide to Cut a Dividend
Transcript
- Lucas: So we've been talking a lot about dividend aristocrats and high yielders, but today I want to dig into something a bit more uncomfortable: the moment a company actually cuts its dividend. And there's a really instructive case we can look at — a mortgage lender that cut its dividend earlier this summer, and the market reaction was swift. Luna: Right, I remember that. The stock dropped something like fifteen percent in a day. But was that an overreaction, or were investors reading the tea leaves correctly? Lucas: That's exactly the question. And I think the answer is: partly. The cut was a surprise, but when you looked at the fundamentals, the warning signs were there. They had a payout ratio above one hundred percent, and free cash flow was negative for two straight quarters. That's a classic red flag. Luna: So how do you spot that before it happens? I mean, most investors aren't digging through cash flow statements every quarter. Lucas: You don't have to. There are a few key metrics that tell you most of the story. The first is the payout ratio — but you have to use the right earnings figure. Many companies use adjusted earnings, which can be generous. You want to look at the payout ratio based on actual reported earnings, and even better, on free cash flow. Luna: And what's a good number to look for? I've heard anything under sixty percent is safe. Lucas: Generally, yes. For a stable company, a payout ratio under sixty percent of earnings is comfortable. But for a cyclical or high-growth company, you want it lower, maybe under forty. And if it's above eighty percent, you're living on borrowed time unless the business is incredibly predictable, like a utility. Luna: But there's more to it than just the payout ratio, right? What about the balance sheet? Lucas: Absolutely. The second metric is debt. A company can have a low payout ratio but be drowning in debt. If interest rates go up — and we've seen the ten-year Treasury around four point six three percent recently — that interest expense eats into cash flow. So you want to look at the debt to ebitda ratio, and if it's above three, that's a yellow flag. Luna: And for the mortgage lender, what did those numbers look like? Lucas: Their debt to ebitda was around four point two, and their interest coverage ratio was under two. That's tight. And they had a dividend that they were funding with debt. So when mortgage volumes slowed, they had to cut. It's a classic story: the dividend was never truly covered by cash flows, just accounting. Luna: So what should an income investor do with that information? I mean, we're in a market where the S&P 500 is up only point four percent on the week, and dividend stocks are getting attention again. Lucas: Right, and that's actually a good segue. Because when you see a sell-off in growth and a flight to yield, investors might chase high dividends without checking the safety. And that's dangerous. A high yield can be a trap if the dividend is at risk. We talked about Altria earlier this year, and that's a perfect example. Luna: Yeah, Altria's yield has been north of eight percent, but the underlying business is shrinking. Did that signal a cut? Lucas: Not necessarily, but it's a risk. Altria has a lot of pricing power and a loyal customer base, but the volume decline is structural. They've been able to offset it with price increases, but there's a limit. And their payout ratio is over eighty percent of earnings. So you're getting a high yield, but you're also taking on the risk that they might have to trim it if the declines accelerate. Luna: So how do you decide if a dividend is worth the risk? Is there a checklist you use? Lucas: Yeah, let's walk through a quick framework. First, look at the payout ratio based on free cash flow, not earnings. Second, check the balance sheet: debt to ebitda and interest coverage. Third, look at the industry and see if there are structural headwinds. Fourth, check the dividend history — have they maintained it through recessions? Fifth, look at management's commentary: are they committed to the dividend or are they vague? Luna: That's a solid list. But can you give an example of a company that passes all those tests? Maybe one that's been in the news recently. Lucas: Sure. Johnson & Johnson is a good one. It's a dividend aristocrat, but more importantly, its payout ratio is around fifty percent of free cash flow, and it has a fortress balance sheet with a debt to ebitda of about one point five. And its business is diversified across pharma, medical devices, and consumer health. That's a pretty safe dividend. Of course, there are always risks, but it's about as close to a sure thing as you get. Luna: And on the other end, you have companies like the mortgage lender that look tempting with a high yield, but they don't pass the sniff test. Lucas: Exactly. And that's why I think the most important thing is to focus on total return, not just yield. If you buy a stock with a six percent yield and it cuts the dividend by fifty percent, your yield drops to three percent, and the stock price likely tanks. So your total return is worse than if you'd bought a four percent yielder with a safe dividend. Luna: That makes a lot of sense. And I think a lot of listeners would benefit from that mindset shift. If you're investing for income, you want to think about the sustainability of that income, not just the number. Lucas: Right. And you know, it's funny — we often talk about dividend stocks as if they're boring and safe, but the reality is that a dividend cut can be devastating to your portfolio. So it's worth spending the time to understand the metrics. Luna: Totally. And I think this episode is a good example of how our conversations can help you think about investing more critically. And if you found that useful, you know, we keep this show ad-free, and that's only possible because of listener support. If you ever want to show appreciation, you can buy us a coffee at buy me a coffee dot com slash fexingo. Lucas: Yeah, that's a nice way to put it. We don't do ads, and we appreciate anyone who feels like contributing. But no pressure, we're just glad you're listening. Luna: Absolutely. So back to the numbers — we mentioned the ten-year Treasury at four point six three percent, and that's actually relevant here because when bond yields are that high, you have to compare dividend yields to that. If a dividend stock yields five percent but is risky, maybe you're better off in Treasuries. Lucas: Exactly. That's the opportunity cost. And that's why I think the focus on safety is even more important in a rising rate environment. The ten-year has been up and down, but it's still around four and a half percent, so you need a dividend yield that's not just high, but reliable. Luna: And that's why I think a lot of investors are looking at dividend ETFs like VYM or SCHD, which have yields around two to three percent, but they offer diversification across many companies, so the risk of a single cut is spread out. Lucas: Right. And that's a good point. An ETF like SCHD, which is up one percent on the week, focuses on dividend growth and quality, so it tends to screen for the metrics we talked about. But even with an ETF, you should do your homework on the underlying holdings. Some dividend ETFs include high yielders that might be risky. Luna: So what's your takeaway for someone who's just starting to build an income portfolio? What should they focus on first? Lucas: I'd say start with a core of dividend aristocrats or quality dividend ETFs, and then if you want to add individual stocks, use the checklist we talked about. And always ask yourself: if the dividend is cut, would I still be okay holding the stock? If the answer is no, maybe you shouldn't buy it in the first place. Luna: That's a great rule of thumb. And it also ties back to having a diversified portfolio, so you're not reliant on any single dividend for your income. Lucas: Exactly. Diversification is your friend. And remember, even the safest dividend can be cut in a worst-case scenario, so build your portfolio as if it might happen. Luna: Well, this has been a really practical episode. I feel like I have a better sense of what to look for when I'm evaluating a dividend stock. Lucas: Glad to hear it. And I think the key takeaway is that dividend investing isn't just about yield, it's about the sustainability of that yield. Do your homework, and you'll be able to avoid the traps and enjoy the compounding that dividends can provide over time.