Some companies are cutting dividends as the economy weakens. A recent Barron’s article lists about sixty firms that eliminated, suspended, or cut dividends since February. We decided to look at the fundamental characteristics of the companies cutting dividends. To do this, we created an equally-weighted portfolio comprised of the stocks in the Barron’s article and asked several questions. What was the dividend yield at the end of last year, before coronavirus hit? What was the financial profile of the dividend cutting firms based on profitability, leverage, and dividend policy? Finally, what happened to the stock prices of those firms which opted to cut dividends?

Beware The Allure of Yield

The dividend cutters were priced to yield 3.5% at the start of the year, much higher than the 1.8% average large-capitalization domestic stock yield (S&P 500). But this is where the advantage seems to end. Through May 7, the dividend cutter portfolio returned -40% versus a -9% return for the S&P 500. We are again reminded that yield and return is not the same thing!

But was it the dividend cut or weak underlying fundamentals that really did the damage? Or the coronavirus recession? We have long made the case that weak fundamentals are almost always at the root of company risk, including risk to the dividend.

Consider that this year’s dividend cutters had:

  1. Lower Profitability
    Return on assets (net income/assets) was 0% for the dividend cutters versus 2.8% for the average S&P 500 company.
  2. Higher Debt Contribution to Firm’s Overall Value
    Debt was 52% of the average dividend cutting firm’s enterprise value versus 23% for the average S&P 500 company. Enterprise value is the sum of the stock price plus net debt per share.
  3. Higher Debt vs. Cash Flow1Earnings before interest, taxes, depreciation and amortization
    Debt to cash flow was 4.9x for dividend cutters, on average, this year. For the average S&P 500 company, this figure is only 0.4x.
  4. Aggressive Dividend Policy
    The average dividend cutter pays out 75% of net earnings as dividends based on the last 12-month results. This is much higher than the 50% payout ratio for the average S&P 500 company.
Quality Matters Most

This does not mean that all companies that suspend or reduce dividends during this extraordinary time are wrong. Some good quality firms may elect to delay payments out of an abundance of caution, while some low-quality firms may find creative ways to keep paying dividends when they should not. More often than not, hidden weaknesses among unpredictable, highly-indebted, or unprofitable firms eventually become exposed. Sadly, these same firms often lure income investors with an above-average yield. Quality ultimately matters far more than yield.

Cash Remains Key

We believe sustainable and growing cash flow drive returns in the long-run. But for portfolio companies to achieve growing cash flows over the long-haul, they must first survive difficult times. Today’s dismal stock price performance from Barron’s list of recent dividend cutters reminds us why it is so essential to always focus on fundamentals over yield. Higher yields most often come at a cost — a cost measured as lower growth, higher risk, or some combination of both. The penalties for weak fundamentals this year are dividend cuts and a 40% decline for many financially vulnerable firms.

For more on Washington Crossing’s dividend investing philosophy, please read “The Case for Rising Dividends.”

“Reopening” Proceeds

Stocks rose last week as more Americans focused on “reopening.” The S&P 500 ended at 2,929, up 31% from the March 23 low and down 13% from the February 19 high watermark. Weekly covid-19 cases and deaths fell -5% and -3%, respectively. Flights jumped by 22%, and transit activity rose 7%. Weekly unemployment claims fell 18% to 3.17 million. Credit spreads and S&P 500 profit forecasts were flat. Measures of real economic activity measured by the New York Federal Reserve fell for the ninth consecutive week.

Extraordinary and Astounding

The rally from the bottom is both extraordinary and astounding. It is extraordinary because, if the March 23 bottom holds, this year’s rout will be the shortest bear market in history. It is astounding because the rally occurred during a time when 77 thousand Americans died from Covid-19 and 33 million Americans became unemployed.

Only time will tell how this all plays out. For now, we continue to focus on owning the best quality companies we can find.

S&P 500 — The Standard & Poor’s 500 Index is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

Indices are unmanaged, and it is not possible to invest directly in an index. All benchmark returns presented are provided to represent the investment environment existing during the time periods shown. Actual investment performance will vary due to fees and expenses. For comparison purposes, the benchmarks include the reinvestment of income. The benchmarks are unmanaged and unavailable for direct investment.

The S&P 500 High Beta Index measures the performance of 100 constituents in the S&P 500 that are most sensitive to changes in the market. Constituents are weighted relative to their level of market sensitivity, with each stock assigned a weight proportional to its beta.

The S&P 500 Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The index benchmarks low volatility or low variance strategies for the U.S. stock market. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.

Disclosures:

WCA Barometer – We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. Analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.

Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

S&P Global (SPGI) is a leading American provider of financial information, analytics, and credit ratings, headquartered in New York, NY. It operates major divisions including S&P Global Ratings, S&P Global Market Intelligence, S&P Global Commodity Insights, S&P Global Mobility, and S&P Dow Jones Indices.

The ICE BofA U.S. High Yield Index is an unmanaged index that tracks the performance of U.S. dollar denominated, below investment-grade rated corporate debt publicly issued in the U.S. domestic market.

The S&P 500 Growth measures constituents from the S&P 500 that are classified as growth stocks based on three factors: sales growth, the ratio of earnings change to price, and momentum.

The S&P 500 Value Index measures constituents from the S&P 500 that are classified as value stocks based on three factors: the ratios of book value, earnings and sales to price.

The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.

The WCA Rising Dividend Custom Benchmark is a rules-based benchmark constructed by Washington Crossing Advisors to represent a universe of large capitalization U.S. companies that meet certain quality and dividend growth criteria, including proprietary screens for profitability, earnings consistency, and balance sheet strength, along with minimum market capitalization and dividend growth requirements. The benchmark is reconstituted and rebalanced quarterly and is intended to serve as a style-appropriate benchmark for the WCA Rising Dividend strategy.

The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.

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The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio relative to the market as a whole. A beta of one is considered as risky as the benchmark and is therefore likely to provide expected returns approximate to those of the benchmark during both up and down periods. A portfolio with a beta of two would move approximately twice as much as the benchmark.

Standard deviation is a measure of the volatility of a security’s or portfolio’s returns in relation to the mean return. The larger the standard deviation, the greater the volatility of return in relation to the mean return.

Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.