EP40: Part 2 - How do you know if the dividend is safe?

Ever wondered how to spot a safe and sustainable dividend? Or perhaps been lured by a tempting dividend yield only to fall into a trap? Fear not, because in this session, I'm taking a deep dive into the realms of dividend investing. Expect to walk away with a sound understanding of how to evaluate dividend safety, the significance of consistent earnings and dividend growth, and the importance of payout ratios. 

I cover the following topics in this episode:
- Review the history of companies paying dividends
- Look for earnings and dividend growth
- What is a dividend trap?
- How to avoid a dividend trap

Watch till the end to get 10% off coupon code for Simply Investing.

Learn more at: https://www.simplyinvesting.com/

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Transcript

Speaker 1: 0:00

Before you invest in any dividend stock, how do you ensure that the dividend is not going to get reduced or eliminated? Hi, my name is Kanwal Sarai and welcome to the Simply Investing Dividend Podcast. This is part two of our previous episode and it's a continuation of our topic Is the Dividend Safe? How do you know if the dividend is going to be safe? So in part one in the previous episode, we covered these four topics and you can see them up on the screen now. So if you haven't watched part one, i highly recommend that you go back and watch part one first before continuing with this episode today. So in part one we covered what are dividends, two reasons why dividends are important to you as an investor, what happens to your investment when a dividend is cut and what is the payout ratio. And then in this episode we are going to look at the history of companies paying dividends. Quick review of that. We're going to look for earnings and dividend growth. Then we're going to look at what is a dividend trap and how to avoid a dividend trap.

Speaker 1: 1:25

So let's do a very quick recap from our part one and before we jump into part two. So, as you know, dividends are profits that the company shares with you, the shareholder. So in this example, if a company is paying a dividend of $1 per share and you own a thousand shares, you will receive $1,000 every year for as long as you own those shares and as long as the company continues to pay the dividend, add money gets deposited directly into your trading account as cash, so you can spend the dividends if you wish or reinvest them, and the dividends are paid to you regardless of share price. Stock price can go up and down, but as long as the company is committed to paying the dividend and as long as you hold on to those shares, you will receive those dividends. Now, dividends provide two reasons here. Why they're important is that they provide you with income and margin of safety, and we saw that in part one our example with RBC, the Royal Bank of Canada, largest bank in Canada, and you can see that the total dividends received since 2010 was almost matching the total investment that was originally made in this company. So the dividends provide you with a margin of safety And in this example, within the next eight to 10 months, the total dividends received will exceed the total amount invested in this company, and then, at that point, your risk has gone down to zero.

Speaker 1: 2:58

The stock price can go down. You're not as worried because you have already made your money back in those dividends. Now, in fact, you've made more because, hopefully, since 2010, you were taking those dividends and reinvesting them into other stocks that were paying dividends. So they were paying you dividends, plus this stock right here, rbc. So your total dividends earned on this $5,000 investment would most certainly exceed $5,000 total income. So that's your margin of safety.

Speaker 1: 3:33

Without dividends, then you're only hoping for the stock price to keep going up, and if the stock price tanks, well then your entire investment is in that stock is going to be down. Now keep in mind and this was covered in part one if the dividend is eliminated, then your dividend income, of course, is going to go to zero in that stock. If the dividend is reduced, your income is also going to get reduced. Now, any of those actions will cause a drop in the stock price. Why And again we saw this in part one Every time the dividend is cut, the dividend yield comes down, and when the yield is really low, investors don't want to take that risk.

Speaker 1: 4:15

Why would they invest their hard earned money into a stock that's paying a dividend of 0.5% or 0.01%, when they could put that money in a term deposit and make 3, 4, 5% without any risk. So when that happens, investors shy away from the stock, and when they start shying away or start selling, then the stock price is going to drop. So then in part one we ask the question is there an early warning sign to tell us that, hey, maybe a dividend cut or a reduction is coming? and The answer is yes. So one of the ways is to look at the payout ratio, and we did that in part one. We looked at RBI, restaurant brands international, and we compared it to Wendy's and you could see that the payout ratio For restaurant brands, with 67% for Wendy's, it was a hundred and nineteen percent, all things considered, equal. If you were looking at these two companies, you would consider restaurant brands international and for now you would have avoid Wendy's because the payout ratio is too high. We don't know if they're gonna have to cut the dividend or they have to grow their earnings, and so there's more risk there for us as investors. And then the last thing we talked about was Another sign, in case you missed the payout ratio. Another sign of bad news is When the company reduces the dividend, and the example of six flags. We covered that in part one. In 2020, they cut the dividend to 25 cents. So that, right, there should have been a red flag that maybe this is a company You should avoid Investing in. Or, if you already own the shares, maybe consider selling them, right, but that's That's also a separate topic for another episode on when to sell. But okay, so that's a quick recap of part one.

Speaker 1: 6:01

Let's jump right into part two, this episode, right now. So we're gonna look first at a review the history of companies Paying dividends. So here's a great example We're looking up on the screen here. This is a graph of Canadian utilities and you can look at the dividends per share and you can see the dividends per share have gone up every single year consecutively, and this chart goes to nine starts at 1999 and you can see it's a nice Good slope that's going up. On the other hand, if you look at a company like General Motors, you can see that the dividend is zero. Then the dividend goes up, then the dividend gets cut again to zero. Dividend goes back up again, then it's cut again. This is completely random. Now, if we look at both of the graphs side by side, which one instills confidence Right. When I look at the first one Canadian utilities I can have a high degree of confidence that this company Will continue to pay me a dividend and hopefully increase it in the future.

Speaker 1: 7:03

When I look at General Motors, it's too random, it's unpredictable. I don't know if the company is going to pay a dividend next year. I don't know if they're going to cut the dividend next year. We don't know. So the key here is to look at a company's history and to see that they've consistently not only paying a dividend but growing the dividend over time. So here's a couple of examples that I've picked out so you could see Coca-Cola has had 62 years of consecutive dividend increases. Johnson and Johnson 62 years of consecutive dividend increases. Black and Decker 55 years of consecutive dividend increases. Pepsi 51 years. Think of how many recessions we've had in the last 50 60 years, how many market crashes we've had in the last 50 60 years. But yet companies like these have continued to grow their dividend year after year after year after year. And Remember, every time the company increases the dividend, that's more money in your pocket. Now, in fact, that was just a very small list. There's a bigger list. If we look at the last 50-60 years, if we look at companies which we refer to as the dividend aristocrats, these are companies that have had 25 years or more of consecutive dividend increases. So in the US today alone, there are 65 companies, and In the US today alone, there's 48 companies which we refer to as dividend Kings. So those are companies with 50 years or more of consecutive dividend increases.

Speaker 1: 8:42

Now let's move on to our next topic. We want to look at earnings growth and dividend growth. Remember, earnings is how much profit the company is making, so we want to look at that and dividend growth together. So here's some Canadian energy companies, just a small sample of companies here up on the screen. These numbers are Not current, of course, when you're watching this video. They were current a while ago But nevertheless, as an example, we can take a look at this. So we can take a look at the first company on the list Canadian natural resources. You can see that the average EPS growth over the last 20 years Is 94%. Now let's contrast that with The company at the bottom of the list, which has an average EPS growth of negative 22%. So again, all things considered, equal. Do you want to invest in the company that has a history of growing its earnings or a company that has a history of losing money, right? so I think the answer is clear. So that's first. We want to look at earnings growth, and you can see on this graph here the companies are sorted from highest earnings growth to the lowest, so you want to focus on the companies at the top of the list, first. Now the second.

Speaker 1: 10:00

The next column over is dividend growth, and so here again we see Canadian natural resources. Over the last 20 years, average dividend growth has been over 19%. We compare that to ARC resources The average dividend growth has been negative, 5%. So the same question is going to apply here Do you want to invest in a company that grows the dividend over time, has a history of doing that, especially over 20 years, or do you want to invest in a company that is reducing its dividend over time? So it's important to look at the next column, which is dividend growth, and also look for a company that has high dividend growth. And the third column over is the number of earnings increases in the last 20 years. So again we can see company like Canadian Natural Resources has had 15 earnings increases in the last 20 years, versus the last company on the list, which has had seven. So you want to look at all three of these columns together when you're deciding which company is worthwhile investing in and which one you should avoid.

Speaker 1: 11:13

Okay, our next topic here. I just want to give you a quick example. We're going to compare two companies, again back to back. But instead of looking at the dividend graph now we're looking at the earnings graph. So you can see, here's the earnings graph for Canadian National Railway since 1995. And you can see, you know, there's a few sort of dips where the earnings go down, but then they come right back up again. What we're looking for here is the overall trend. So since 1995, you can see that the trend has been. It's moving up. So the earnings in the long term continue to grow. You might have one or two bad years where it drops, but over the long term we want to see earnings growing. Compare that to Nokia.

Speaker 1: 11:58

So here's a company that makes money. Then they lose money. You'll notice in the graph we have a negative right, negative dollar 20. So it loses money. What I was going to say is not just break even, but lose money. So here the graph goes up and down, up and down, up and down. It's random. It's very difficult for us to have any confidence as to what is going to happen to the earnings next year. And remember, when the earnings are down, then the company is under a lot of pressure to cut the dividend And as dividend investors we don't want to see the dividend get cut. So better to focus on companies that have a history of have a track record of growing their earnings, versus just up and down all the time.

Speaker 1: 12:44

Okay, now let's move on to our next topic What is a dividend trap? Now, basically, a dividend trap is when the dividend yield is too good to be true. So let's take a look at four different shipping companies. So they're all in the same industry. Let's take a look at them right here on the screen. Now, if you take a look at our column for current dividend yield right here, you can see the first company has a yield of 1.1%. Second one has a yield of 1.7%. The third one on the list is 3.7%, and then we have a company at the bottom of the list, golden Ocean Group, at a yield of 27.8%. Now that is huge. If you look at that number, it is extraordinarily high And automatically.

Speaker 1: 13:37

You might be thinking then why should I invest in a company that's only paying a dividend of 1% or 2%? And I can put my money in this company and I can make 27% return. Why wouldn't I just do that? no-transcript, there's more to it. Remember what I said in the previous slide if the dividend yield is too good to be true, it probably is. Now Let's take a look at why that's the case. So the dividend yield, as you know, is the dividend divided by the share price.

Speaker 1: 14:05

So in this example, a dividend is $1, the share price is 20. 1 over 20, expressed as a percentage, is 5%. Now what happens when the company Stock price drops? So the dividend stays the same, but the stock price drops to $15. Now my yield is 6.7%. If the stock price drops again to $10, you can see the yield is 10%. If the stock price drops to $5, it's the yield is now 20%. So every time the stock price drops, what happens to the dividend yield? the yield goes up.

Speaker 1: 14:43

Now, in this example on the screen, there's a reason why the stock price is now trading at $5. There's a reason why it went from 20 down to 5. Now we don't know the exact reason. This is just an example. We're looking at it on the screen here, but more, more, more likely, most likely that's what I wanted to say is most likely There is something going on with this company.

Speaker 1: 15:13

Either there's negative news Or the company is performing so badly, earnings are down, debt is high, there is something going on that is causing the market To devalue this company and the stock price has dropped to $5. So when the stock price drops to $5 in this example, the yield is going to be very high, like 20%, and I can tell you from experience Do not get greedy. Do not chase after high dividend yield. So I purchased Washington Mutual Years ago, before the 2008 2009 financial crisis, the yield was almost 10% And I didn't look at anything else. I got greedy, bought the company and about nine months later, the company was bankrupt and Lost all of the holdings in Washington Mutual. So learn from my experience. Don't make the same mistake again and Avoid companies when the dividend yield is extremely high and you can see here, it's extremely high.

Speaker 1: 16:20

And if we look at the again, this is looking at Golden Ocean Group. We're gonna look at their stock price. Take a look at the drop right. Since 2016, the stock price has dropped Drastically and has stayed low for the longest time. So there's something going on here And if you have the time and energy, you could research it. You could try and figure out what's going on. But as general, as investors, as dividend investors, to me this looks like a dividend trap, and I've experienced enough of those in the last 25 plus years as a dividend investor That I will now stay away from those and I advocate that you do the same.

Speaker 1: 17:02

So the last topic in this episode is how do you avoid a dividend trap? So if you look at these companies we've got a bunch of companies on the screen. You can see what stands out is this one here, company E, all the other companies the yield is around 1.7% to 2%. That's where the dividend yield is. For all of the rest of the companies, it's hovering between 1.7% to 2%, but company E is sitting at a dividend yield of over 14%. So right there, that tells me if the dividend yield is too good to be true. It probably is.

Speaker 1: 17:43

So how do you avoid a dividend trap? Number one recognize that it is a trap, that the yield is way high than it needs to be. Number two you don't invest in that company. It's as simple as that. Okay, so now does this mean? so you've watched part one, which was our previous episode. You're watching this one here. Part two, and we were looking at is the dividend safe? Now does this mean you should go ahead and invest in any company that pays a dividend and has a good track record of paying dividends? And the short answer is no.

Speaker 1: 18:16

Our approach to investing is to invest safely and reliably for the long term, and my approach what I teach and have been teaching for over 25 years is invest in quality dividend stocks not just any stock, but a quality stock when it's priced low. So how do you know when you're looking at a quality stock and how do you know when it's priced low? I've created what I call the 12 Rules of Simply Investing. This is your checklist. A company should pass all of these 12 rules before you invest in it. Now, for those of you watching, you can see the 12 rules on the screen If you're listening to it. I'll just read them out very quickly here.

Speaker 1: 18:55

Rule number one do you understand how the company is making money? If you don't skip it, move on to something else. Rule number two 20 years from now, will people still need its product and services? Rule number three does the company have a low cost competitive advantage? Rule number four is the company recession proof? Rule number five is it profitable? That's what we looked at in today's episode. We want to look at the earnings growth. Number six does it grow the dividend? And we looked at that as well. Companies have a track record of growing dividends. Rule number seven can the company afford to pay the dividend? Rule number eight is the debt less than 70%? Rule number nine avoid companies with a recent dividend cut, and we saw that with the example of Six Flags in this episode and the previous episode as well. Rule number 10, does the company buy back its own shares? Rule number 11, is the stock priced low? So we check for three things The P-E ratio we compare the current yield to the average yield and we look at the P-B ratio, the price to book value. And rule number 12, keep your emotions out of investing.

Speaker 1: 20:00

So if anybody that's interested, i have an online course, the Simply Investing course. We cover all of these rules in detail and more. There's 10 modules, a self-paced course. We cover the investing basics, the 12 rules of Simply Investing, applying the 12 rules, and I provide you with a Google Sheet So you can apply the 12 rules to any stock anywhere in the world. And then I show you how to use the Simply Investing platform. I show you how to place your first stock order, step by step. I also show you how to build and track your portfolio. When to sell is just as important as knowing when to buy. We look at reducing your fees and risk, and then I provide you with an action plan to get started and I answer your frequently asked questions. So that's in the course.

Speaker 1: 20:49

If anybody who's interested, i also have a platform. We took two years to build the Simply Investing platform. It's a web app and it applies these rules to over 6,000 companies in Canada and the US every single day. So we tell you exactly which companies to focus on and then which companies to avoid. So that's available there. If you're watching this or listening, write down the coupon code SAVE10SAVE10. The coupon code will save you 10% off of all of our product and services, including. I also do one-on-one personal assessments and coaching calls, so you can save 10% off of those as well. If you enjoyed today's episode, be sure to hit the subscribe button, hit the like button as well, and for more information, take a look at our website simplyinvestingcom. Thanks for watching.