Income investors were no doubt relieved by the Fed’s recent decision not to raise interest rates.
Indeed, the continuation of cheap money policy was good news for the stock market, even if it suggests the Fed is worried about global growth.
However, income investors still need to worry about the next recession, as my colleague Alan Gula mentioned on Friday. Based on normal cyclical considerations, that event is likely no more than two to three years away.
Companies have a nasty habit of cutting dividends in recessions and not restoring them afterwards. Even when a company regains earnings after the recession, it may not fully restore its dividend.
For example, General Electric Co. (GE) – among the most solid companies in the United States – was paying a $0.31 quarterly dividend in 2008. It cut the dividend to $0.10 in 2009 and has restored it to just $0.23 today. All the while, the company was wasting time with untold billions of dollars in stock repurchases, which do nothing for the little guy.
Elsewhere, JPMorgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC) restored their pre-2008 dividends only last year, and Citigroup Inc. (C) is still far from doing so – its dividend is only a tenth of the 2007 level, though admittedly it has issued huge numbers of shares in the interim.
Fortunately, there are ways to minimize the risk from recession dividend cuts.
Look Out for Leverage
First, there are qualitative signs that can help identify a company whose dividend is unsafe. Leverage is probably the most critical. If a company has borrowed heavily leading up to the recession, it’s likely to get into difficulties.
This is especially true if the company has acquired the leverage by repurchasing its shares at a big premium to net asset value (NAV). In that case, it may have diluted its NAV to such an extent that, when the recession comes, it has neither cash flow nor hard assets left to pledge for new debt.
In general, share buybacks should be a red flag for income investors. They take cash out of the company, reward management and institutions, and make it less likely that dividends can be maintained during tough times.
Share buybacks from the fashionable “Dividend Aristocrats” – companies that have raised their dividends for at least 25 years consecutively – are also a big problem.
While such a track record is indicative of the company’s ability to survive recessions, share buybacks may deprive the company of the cash it needs to maintain the dividend in a recession. In corporate finance, as in life, aristocrats that spend the family capital without acquiring productive assets quickly cease being aristocrats.
I don’t necessarily expect the next recession to be worse than previous ones, but I do expect it to take a greater toll than normal on the “dividend aristocracy.”
Check the Score
Lucky for us, the mathematical whizzes of modern finance have come up with a way to predict which companies might either fail or cut their dividend in a recession.
It’s called the Merton score after Nobel Prize winner Robert S. Merton. The score is based on the Black-Scholes options valuation model (which Merton was also instrumental in developing), and it compares the value of the company’s assets to its debt.
The Merton Score, or distance to default, is the number of standard deviations by which the asset value exceeds its debt. Now, that may sound complicated. Fortunately, Société Générale and other brokers calculate these scores. For our purposes, we simply need to know that a Merton Score of 1 means the company is quite likely to default and very likely to cut its dividend (since its asset value is only 1 standard deviation above its debt), while a Merton score of 4 or 5 is pretty solid.
Another method of evaluating dividend risk is the Piotroski score, which was devised by University of Chicago Professor Joseph Piotroski. It uses a 10-part checklist instead of standard deviations, and it has the virtue of being rather more accessible to those without a Mathematics Ph.D. and a supercomputer.
Also, while I don’t want to cast stones, I would remind you that Merton was heavily involved in the bankrupt hedge fund Long-Term Capital Management in 1998. His methods are thus not foolproof.
Apart from troubled oil companies, some examples of companies that are exceptionally vulnerable to dividend cuts, according to Société Générale, are the telecoms companies Windstream Holdings Inc. (WIN) and Frontier Communications Corp. (FTR), whose juicy dividend yields of 7.9% and 8.1% are being paid mostly out of cash flow and not earnings. Both have Merton scores of 1.
On the other hand, two stocks that Société Générale likes, both with Merton scores of 5 and Piotroski scores of 7, are Altria Group Inc. (MO) and Singapore Telecommunications Ltd. (SGAPY). Both look rock solid. After all, the world isn’t going to stop smoking altogether, and Singapore Telecom has both landline and wireless businesses in Singapore and Australia.
Bottom line: Dividend investors tend to have trouble sleeping at night, but by investigating your holdings and using Merton and Piotroski scores, you can start to sleep a little sounder.