One of the sad realities of being a dividend growth investor is that management likes to lie.
Far too often, a firm’s management has incentives that aren’t aligned with investors like you and me. I’m a big believer that over time we’ll be able to see which companies are putting their own interests first. The market will punish them in due time.
Sadly, we won’t know about it until after the fact, and we might be caught up in their shenanigans because we’re chasing what looks like a great deal. Getting greedy with your investments is a good way to lose money. Too often I’ve heard people brag about bagging a “fat yield” or an “out-performer” only to see the dividend cut a few quarters later.
I’ve even allowed myself to become a victim of this kind of greed. Nothing stings like having been made the fool.
Today I hope to share a few of the ways that management likes to blur the line so that they can make it look like things are going well. In each of these cases, an inevitable dividend cut is coming, whether this quarter, next quarter or next year.
Get out from in front of the train so you don’t get hit.
Different kinds of dividends for business purposes
All dividends are not created equal.
In fact, there are several different kinds of dividends, and the kind of dividends you’re receiving make a big difference when it comes to whether you’ll still be getting paid later on down the road.
First, I want to explore what I mean when I say there are different kind of dividends from a business perspective.
When a company pays you a cash dividend there are a few different ways they can finance the dividend. Ideally, your dividends are paid out from the after-tax profits of the business.
So, for example, let’s say that the business has revenues of $1,000, and after all the expenses are totaled, earnings before taxes of $154. Assuming the business is subject to a 35% corporate tax rate, it would then be required to pay $53.90 in corporate income tax.
1000 – 846 = 154
154 * .35 = 53.9
154 – 53.9 = $100.10 in after-tax net income.
The company you own now has a couple of options for that $100.10 net income. They can retain it in the business as cash (assuming it is cash), reinvest it, buy back stock, or pay a dividend.
We hope they’ll pay a dividend. Dividends paid from the earnings of a company are called ‘regular’ dividends.
If they decide to use $50 to pay a cash dividend, we’re happy as investors, and we’d like to assume that all dividends are paid out following this scenario.
The reality is they’re not.
5 tricks of the dividend doomed
Sometimes a company will get involved in some shenanigans so that they can continue to pay, or worse, increase, a longstanding dividend payment.
As an investor, you should be aware of what those tricks are, and how to spot them. Typically, a company will use these shenanigans because investors sometimes react poorly to dividend freezes and cuts. To stave off a meltdown in the share price, the company will use one of these tricks to prop up the dividend payment.
Return of capital dividends
The first one you should be aware of is what’s called a capital dividend, or sometimes a return of capital. A capital dividend is when a company pays a dividend out from their paid-in-capital instead of from their earnings.
How does it work? Time for an example.
Let’s assume that Company A has 5,000,000 shares issued and outstanding and has a current dividend policy of paying $0.12 per quarter, for a total dividend payment of $600,000 or $2,400,000 a year.
Let’s also assume that things aren’t going well for Company A. In fact, they’re bleeding cash. They know that come March they won’t be able to pay for the dividend from the company’s nonexistent earnings. In January, the company can hold a follow-on offering of their stock to raise additional capital. Let’s say they sell 1,200,000 shares for a price of $8 a share.
The company receives a cash infusion of $9,600,000. Happy day!
Not only can they now afford to continue operations in the hope of returning to profitability, they can also afford to pay their quarterly dividend.
When they pay that dividend, they’re returning $600,000 in capital to the shareholders, using funds directly sourced from the shareholders. They are destroying stockholder equity. The sad thing is that many shareholders will be caught unaware when, inevitably, things fall apart later and the company has to cut its dividend anyway.
Watch out for this trick, and take it as a serious sign that it might be time to get out.
A variation of this trick is using cash reserves to pay you a dividend instead of paying out from the company’s profits, and you should be just as concerned.
Debt to pay the dividend
Another trick that companies will sometimes use to pay their dividend is debt.
The basic idea is the same as the example we covered above. The company doesn’t have the earnings required to cover the dividend payment that shareholders have come to expect.
Instead of freezing or cutting the dividend, management decides to take on more debt to pay for it. If we’re using the same basic example again, instead of a stock offering the company would secure a line of credit or issue bonds.
While this method isn’t as directly detrimental to shareholders as returning capital, it’s still a terrible thing for management to do. Shareholder’s now have another creditor between them and the business assets, and the business hasn’t done anything to fix the problems causing the cash flow shortage to begin with.
Faking a dividend raise
This trick is a little different than the others, but the main idea is the same.
Essentially, all of these tricks are a way for the business to pretend that things are normal and they’re still operating at a profit when the reality is entirely different.
Sometimes a business will have a payout ratio small enough to continue with its current dividend policy, but earnings have started to decline and won’t sustain the kind of dividend raises the firm had in the past.
Instead of freezing the dividend, the company will raise the dividend by a pitifully small amount so that it can claim a continued streak of dividend raises. For example, a company paying $0.46 a quarter would raise their dividend to $0.465.
Technically, it still raised the dividend, but a 1.09% raise is a token gesture at best.
In my opinion, this is a horrible thing for a company to do. I feel it signals management is more concerned with maintaining the status quo than they are in fixing the looming problems on the horizon.
The “totally normal” one-time event
Let’s pick on Sears a little.
Sears has been going through a tough time for the last little bit. When I say a “tough time” what I mean is you won’t be able to find a store in five years, because it’s sinking like a ship made from sponge. It’s been bleeding off cash and selling stores, brands, and assets left and right.
Sometimes, a company like Sears will have been paying a dividend for a long time. Unable to be honest with investors, management might try to pull the wool over investors’ eyes by selling off a brand and then using that cash to continue paying the dividend.
Sears, for example, did something similar when they sold the Kenmore and Craftsman brands. They tried to paint the sale as a good thing for Sears that added value to shareholders. The reality is that the company made a one-time sale and lost an asset.
Like Sears, a company that uses a sale like this to pay the dividend is destroying shareholder value.
Even worse, a company will sometimes try to use fuzzy accounting to hide the sale as a normal part of their revenues, making it look like they had great operating profits. What they really did was sell the cash cow.
Be on the lookout for any sudden jumps in revenue, and especially look out for dividends financed by discontinued operations or one-time sales.
The “buy what we’re selling” scrip dividend
This one is uncommon, but it still exists and you should be looking out for it.
Sometimes a company will be losing money but want to placate its investors. Instead of freezing or cutting the dividend, they’ll issue something called a scrip dividend.
A scrip dividend is when the company pays you an imaginary dividend.
Okay, not really, but close.
A scrip dividend is when the company admits that they don’t have enough money to pay the dividend from cash reserves or corporate profits so they give you an IOU instead. They’ll promise to pay you the dividend they would have normally paid you, sometimes with interest, when they have the cash.
The idea is like dividends in arrears for preferred stockholders but should be a warning to you. In the case of dividends in arrears, this kind of thing is normal. In fact, it’s part of the incentive for you to purchase shares that don’t carry any voting rights like common stock would.
For a common stockholder, you should be raising your eyebrows and walking away when management tries to take you as a sucker with this kind of thing. Bad things are on the way.
Last points for the dividend investor
If you’re eyeing a company and considering adding it to your dividend growth portfolio, be on the lookout for these tricks.
Although this isn’t an exhaustive list of the things management might do to fool you, you should be aware of them. Also, keep in mind that just because management has cut its dividend doesn’t mean that you’re looking at a bad investment. You should be more worried when management refuses to cut its dividend even when it clearly should.
Lastly, you should be reading about a company’s dividend policy through their investor relations portal or in their SEC filings.
Did I miss anything? What tricks have you seen management try to get away with to fool careless dividend investors? Let me know in the comments.