How Do I Pick Strong Dividend Companies That Can Survive Recessions?

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In these tumultuous times, investing in the stock market may seem daunting.

With many stocks being battered down, they could be selling at enticing dividend yields, giving investors a massive headache when it comes to choosing the sustainable ones to invest in.

Should you pick StarHub Ltd (SGX: CC3), with a dividend yield of 6.3%, or choose Overseas Education Ltd (SGX: RQ1), which yields close to 10%? Or do both companies not make good dividend stocks?

How about Hutchison Port Holdings Trust (SGX: NS8U), which has a much higher dividend yield than say, Singapore Exchange Limited (SGX: S68), but may not necessarily make a good investment for the long-term?

So, to make things easier for dividend investors out there, here are three simple criteria for picking strong dividend companies that have the ability to withstand recessions.

Before we get to the steps, as investors, we must realise that not all dividends are created equal.

A stock that has a lower dividend yield may be a better dividend share than a company with a higher dividend yield. 

A high dividend yield, as compared to its peers, may mean that the company is fundamentally weak and thus, has a depressed share price.

On the flip side, a low dividend yield does not necessarily mean that the company is a lousy one.

It may mean that the company’s share price has run up a lot due to its strong business. 

So, instead of looking at dividend yields in a vacuum, we should focus on three other aspects of a company if we are investing in it for its dividends. 

Those factors are:

  1. Earnings and free cash flow growth 
  2. Dividend payout ratio
  3. Balance sheet strength

Let’s explore why those criteria are more important than the headline dividend yield of a company.

1. Earnings and free cash flow growth

Firstly, dividend companies should exhibit stable growth in both earnings and free cash flow.

Earnings (also known as net profit) are what is left after a company pays off all its expenses, such as cost of raw materials, salaries, and taxes using its revenue. 

On the other hand, free cash flow is cash flow from operations minus capital expenditure.

A company’s free cash flow shows how much money the firm has to dish out dividends to shareholders, buy back its shares, reinvest into its own business, or pay off debt (if any). 

A company with consistently growing earnings and free cash flow over many years hints to us that it has a strong business, and that’s what investors want.

Such a company would also be inclined to pay out higher dividends as its business grows over time.

For example, Singapore Exchange hopes to pay a sustainable and growing dividend over time, consistent with its long-term growth prospects.

On the flip side, a company with falling earnings and free cash flow would be pressured to cut dividends or worst still, stop paying dividends entirely, to sustain its business.

An example of such a company is Hutchison Port Holdings Trust, whose earnings have tumbled over the years, and consequently, seen its dividends being slashed drastically.

2. Dividend payout ratio

The dividend payout ratio tells investors what percentage of a company’s earnings or free cash flow are paid out yearly as a dividend.

I prefer businesses that pay less than 80% of their free cash flows as dividends. 

This gives enough margin of safety in case the business takes a short-term hit for any reason.

For example, if a company has a 50% dividend payout ratio, it would mean that free cash flow has to fall by more than 50% before dividend may be cut. 

A 50% dividend payout ratio would also mean that there’s space for dividend growth in the future if free cash flow doesn’t grow as much, before a 100% dividend payout ratio is hit. 

Some companies have a fixed dividend policy of paying out a certain amount of earnings as dividends.

For example, Valuetronics Holdings Limited (SGX: BN2) has a formal dividend policy of declaring 30% to 50% of its earnings as ordinary dividends each year.

On the other hand, companies that pay out more than 100% of their earnings or free cash flow as dividends may have to cut dividends to bring them to more sustainable levels. 

An example of a company cutting its dividends is StarHub. It had to slash its dividends from 2017 onwards as they were unsustainable.

3. Balance sheet strength

The balance sheet reveals the financial strength of a business.

Companies with lots of cash and little or no debt have the financial muscle to navigate through tough economic conditions.

Such companies don’t have to worry about paying off exorbitant interest expenses when revenues get hit during tough times.

Banks hounding on their backs during a recession is the last thing that companies want.

As mentioned earlier, free cash flow can be used to pay dividends or pay off debt.

If a company doesn’t have loans to deal with, it can focus on things that matter, such as keeping shareholders happy with higher dividends or reinvesting into its business for further growth.

It can also use the opportunity to acquire other companies at cheaper valuations during an economic downturn, setting itself up for greatness when the economy recovers. 

Parting Thoughts 

I hope that you are now armed with the right knowledge to pick dividend companies that can withstand recessions.

Don’t get me wrong.

If companies possess all three criteria listed above, it doesn’t mean that their dividends are 100% guaranteed (nothing is guaranteed in investing anyway).

It just means that you tilt the probability of investing in companies that pay out sustainable dividends in your favour.

With that, happy dividend hunting!

Dividend Play

Should we choose to buy companies that pay lots of dividends or companies that pay very little dividends but create a lot of shareholder value?

Berkshire Hathaway, Warren Buffett’s company has not paid a single cent in dividend so far. All the profits accrued are all pumped back into the company to make the company grow. That’s the reason why it’s now the world’s most expensive stock at $115,815/share now. Warren Buffett says that every dollar of retained wealth by the company should create a dollar of market value. If the company cannot do so, it should return the money to shareholders via dividends so that the investors can invest the money elsewhere. Since shareholders want the value of the business to increase, Warren Buffett ploughs the company profits back into his business as he believes he can create the value.

Personally, I prefer the company to retain its profits and invest into its own company to create more value. If it cannot do so, the profits should be returned to the shareholders, just like what Buffett believes. If the dividends paid yearly increases with increasing share price, then it’s a great buy. However, before looking at the dividends, it should be analyzed if the company can create profits year-on-year and thus increase its yearly dividend payout. It should also fulfil all the other value investment criteria like low debt, high ROE, high free cashflow, etc.

To see if the company can pay out dividends consistently and with increments, I look at whether the free cashflow generated yearly increases. I also look at historical dividend payouts and if they were increasing year-on-year. I prefer to invest in companies with dividend yield of more than 4-5%. However, if the dividend yield is low but the company has been growing astoundingly with high ROE, I might still invest in this company as the profits are ploughed back into the company to generate more profits.

Let’s see what yearly increments of dividends can do to the dividend yield. Let’s say you bought a company, Dividends So Shiok Pte Ltd (DSS for short). The price you bought at was $5. The total dividends paid for the first year was $0.30. This gives a dividend yield of 6%. 10 years later and you are still holding on to the stock. The dividend growth rate and share price growth rate is 6%. At the end of 10 years, the stock price will be $8.95 and the dividends for the year will be $0.54. The dividend yield now becomes 10.8% on your original $5 investment. This is the power of compounding.

Lastly, always remember not to use your dividends to splurge on stuff. Use the dividends to buy more stocks to compound your growth.

Lionapac has gone XD

Lionapac went XD today and it has dropped 30% so far at the time of writing. Yesterday’s close was at $0.345 and now, it’s at $0.24. It opened at $0.255 in the morning. Looking back, I’m fortunate that I didn’t buy the counter. Even with my stringent cut-loss levels that I planned for, the levels would have been been trashed hands-down even before market opening.

Lionapac’s Massive Dividends

Recently, one of my NS friends told me that a counter he holds, Lion Asiapac, is giving out huge dividends of $0.10/share (XD: 13th July 2010). So, I was interested in getting hold of the stock if it was a good buy after all. I went to research it to find out if it was worth buying even for the short-term. It does not closely fit the value investing tenants though. Current share price is at $0.34. Here goes the research:

Before XD

Previous massive dividend paid on 26th April 2010: $0.15/share. This amounts to a total of $60.828 mil (the total outstanding shares used for all the calculations: 405,523,000 ). The company announced on 20th May that it will invest $9.3 mil investment into Mindax Ltd- an ASX-listed company involved in minerals exploration. $60.828 mil+$9.3 mil=$70.128 mil (total paid for dividends and investment). In the balance sheet as of 31/3/2010, the cash stands at $188.416 mil. So, $188.416 mil-$70.128 mil= $118.288 mil. This figure divided by total outstanding shares will give a cash of $0.292/share. The NAV at this point of time is $0.369 (total assets-total liabilities/outstanding shares). Their current ratio is stand at 17.91, assuming no changes to other components like PPE, trade payables and borrowings.

After XD (after 13th July 2010)

After the $0.10/share dividends are given off, the cash balance in their balance sheet will surely drop. A total of $40.552 mil will be exhausted after giving the dividends. Cash balance left on balance sheet will be $77.736 mil. The cash/share will stand at $0.192/share. The NAV will stand at $0.269. Their current ratio will stand at 11.49, assuming no changes to other components like PPE, trade payables and borrowings.

On 1st July, when the announcement was made the previous day that $0.10/share dividends will be given off,  the share price shot up 30.8% from $0.26 to $0.34 (refer to image below)! On hindsight, it would have been awesome to hold the stock before 30th Jun to capitalize on the capital gain and dividends. Also, when bought at $0.26, there was a huge margin of safety as NAV and cash/share were all above $0.26.  Now, is it worth it to buy the stock? In my opinion, it will be quite a risky buy. If I were to buy in, I would buy at $0.33 as comparing to the previous round of dividends, the lowest the stock came down was 1 cent (refer to image below, highlighted in purple). At $0.33, it’s a 11.8% margin of safety (MOS) from the NAV of $0.369. Also, there might be a possibility of next round of ‘jumbo’ dividends as the current ratio will stand at a high of 11.49 with negligible debt at $361,000. Management may give out dividends again if they are not going to use it for investments or expansion. As I said at the start, this is not a value investment strategy.

The best price to buy the stock now will be at $0.28 which is at 25% MOS from its NAV and $0.28 is also below the cash/share of $0.292.  At $0.28, I feel it will be a risk-free purchase considering the management may give out a 3rd round of dividends. Looking at the technicals, the RSI is at an overbought level as well.

If I were to buy at $0.33, I would have stringent cut-loss levels as well to make sure the dividends I receive do not get eroded.

Lionapac Techincals:

Dividend infomation:

*Disclaimer: This post is not a recommendation to buy Lion Asiapac. The writer will not take any responsibility arising from any losses incurred by the individual by buying the stock.