Management incompetence and dividend paying stocks are not mutually exclusive concepts. Even though research shows that dividend paying stocks tend to consist of the majority of stock market returns during down markets, it cannot be concluded that all dividend paying stocks will ride out all economic cycles smoothly. A 24 month period of dividend decreases and dividend freezes has made most dividend investors all too aware of the fact that dividends do not always go up.
As we settle into a year of the unknown, what warning signs should dividend and income trust investors look for to determine if a dividend paying stock or income trust may be going down the wrong path. The following are 3 real life examples:
Moving away from organic growth to new business lines. Kingsway Financial Services is a mid-cap company which became successful providing insurance to higher risk drivers and truckers. At its very peak, it was paying a 7.5 cent dividend per share a quarter; a respectable dividend for a mid-cap stock. However, in many respects, its success sowed the seeds of its own destruction.
Flush with confidence, it started a rapid expansion into the United States, a market which it had little experience in, and into other business lines (it bought a hurricane insurance company at one point which stretches the concept of synergies). The company, at its peak, had 9 operating units- quite a lot for a mid-sized company. Then, the bottom fell out.
The company’s downfall was partly due to declining economic conditions and partly due to bad underwriting. Underwriting mistakes, which means you underestimated the risk of loss, often happens if a new entrant under-prices itself to gain market share or does not understand the business well.
In 2008, it began to divest of assets. So much so, it gave away the shares of one of its subsidiary to a charity to avoid taxes (this transaction is now under investigation). The stock traded in the mid-teens five years ago. It now trades for less than $2 and it pays no dividend.
Kingsway is a good example of how empire building can destroy shareholder value. Investors want dividend growth but one has to be careful how a business is pursuing this growth. If the company begins moving away from its niche, it can be seen as a warning sign. Kingsway is but a recent example. TransCanada’s dividend cut of 1999 was the end result of a business moving out of its core competence to empire building. The silver lining for TransCanada was it had a significant economic moat in its main business line to recover from this error.
The company is over-generous in its pay-out policies. This warning sign is unfolding as we speak to Riocan REIT. Many have wondered whether Riocan was overly generous in its distribution policies during good times. In particular, its distribution policies seemed to be premised on the assumption that profits from the sale of properties would supplement regular rental income.
This led to the unusual situation of Riocan’s occupancy rate increasing in 2008 and 2009 but increasingly distributing more than it brought in; the lesson being fluctuations in earnings, especially premised on big transactions, coupled with high payouts can be warnings signs to dividend investors.
According to Riocan’s financial statements, for fiscal 2008, it paid out 102.9% of adjusted funds from operation (adjusted funds from operations, or AFFO, is a non-GAAP measure that is a “true” measure of cash flow in a real estate concern). For fiscal 2009, it paid out 127.2% of AFFO or it took in $1.00 and paid out $1.27.2.
This situation is mitigated somewhat by the fact Riocan offers a dividend reinvestment program which allows the company to pay distributions in shares rather than cash. The result is that in 2009 it took in $1.00 and paid out $1.04.5 in cash and the remainder in shares.
One wonders how much longer this situation can be sustained. Alternatively, economic prospects brighten and the increase in cash flow puts the company at a cash flow even position. In this situation, does management push the company back to an unsustainable payout betting on a long term recovery? Cautious investors would probably say no and want to pay it safe.
The lesson being watch out for a company that pays out dividends and income trust distributions generously as a means to entice new investors. It could be building a house of cards that may fall in bad times.
A change in management philosophy. Too much debt is the enemy of the dividend investor. Lenders can force dividend paying companies to slash its dividends through covenants found in loan agreements or, more subtly, force companies to slash dividends as a condition of maintaining credit facilities.
As we work our way through the recovery, a dividend investor in a high debt company may face a double whammy. A difficult re-financing market for some industries may force the company to free up cash by slashing the dividend or there may be a change in philosophy about risk tolerance levels.
Manulife Financial is perhaps one of the more (in)famous example of a change in management philosophies about risk and debt. Under a CEO that attracted a lot of press, a company which managed risk for a living began to take risks itself. In the beginning, such risk taking was rewarded by the market and earnings translated to increased dividend payments to investors. However, the risk taking lead to the company incurring large annuity related obligations it will have to pay in the future-with the underlying assets to pay for such obligations reliant on the performance of the market (some of this exposure is unhedged).
The CEO who oversaw the creation of this situation had a much more liberal view of assuming debt than his successor and some believe that he was more interested in creating an asset management company than operating an insurance concern (see my first point above). The new CEO slashed the dividend- twice- in order to give the company financial flexibility and appears to have a very conservative view of incurring any new liabilities.
This factor bears special attention since the super star CEO who thought he was an i-banker may be giving way to more custodial type management. American banks notwithstanding, the accountants and operational people seem to be taking over from the deal making CEO’s (see Walmart, Rogers, CN).
The lesson being be careful of the company that increased dividends by taking greater than normal risks. It some point, its corporate culture may kick back in and revert back to its more conservative ways at the cost of the dividend.
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None of these factors alone spell trouble for a dividend paying company but they should be warning signs and signal to an alert investor to keep a close eye on the situation.
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