Dividend Safety

I don't normally invest in individual companies -- though I will make exceptions. I'm retired so my days of high-growth investing are mostly over; having said that, I still want some growth in my portfolio. But I want income, and besides bonds, which are pretty boring, I like dividends. 

 But if you're investing for dividends and you're investing in a company, you must insure dividend sustainability. When a company reduces or suspends its dividend, the normal result is the stock will tank, erasing all your gains and creating a loss. 

(This is why I'll invest in an ETF that focuses on dividends, especially if they pay out monthly, which individual companies don't do. This spreads the risk around).

The most important factor is a company’s payout ratio. This is the percentage of net income a company pays its shareholders as dividends. The lower the payout ratio, the safer the dividend payment.

The second factor is the company’s debt-to-equity ratio. The more debt a company has, the harder it is to run a business. This includes paying a dividend.

The third factor is free cash flow. This is the cash leftover after expenses.

When any of these factors flashes red, it means a company’s dividend is in trouble.

Warren Buffett, one of the greatest investors of all time, must have overlooked this when he bought a 27% stake in Kraft Heinz (KHC) in 2015.

Not long after, Kraft’s sales flatlined. Earnings rose slightly, but this came from cutting costs, not growing sales.

Nevertheless, Kraft kept raising its dividend—until it couldn’t.

In February 2019, the company slashed its dividend 36%. The news pushed Kraft off a cliff. Shares plummeted 30% in a single afternoon, dropping from $49 a share to $31. It still hasn't recovered.

Let's take Kellogg (K) as another example. It currently sells for about $66 per share and has a dividend yield of 3.42 percent, which is nothing to right home about anyway, unless it was a growth company, which it is not.

 It hasn't cut its dividend yet, but it doesn't pass the small test for sustainability, in my opinion.

First off, Kellogg’s payout ratio is 106%. That’s bad. It means the company pays $1.06 in dividends for every $1 in profits.

Even worse, this is “normal” for the company. Its average payout ratio for the last five years is 107%.

Meanwhile, Kellogg has a lot of debt. Its long-term debt-to-equity ratio is 281%. And its free cash flow has sunk an average of 6% per year over the last five years.

These are warning signs. Pay attention, please.