Few financial topics have been the subject of more articles than dividend investing, and for good reason: Owning equities that pay regular dividends can be a good long-term income strategy — with the right stocks.
Yet when considering stock purchases, investors shouldn’t let their desire for dividend income eclipse other selection criteria. Paramount among these other criteria are factors indicating potential for growth based on fundamentals. Unfortunately, investors distracted by the shiny object of dividends may fail to examine a company’s financials.
Though not always accurate, the image of companies that pay reliable dividends is generally one of financial stability, indicating likely growth. Especially prized for their dividend streams are companies known as dividend aristocrats — large companies that have increased dividends annually for at least 25 years.
Foregone Conclusion
This inflexible criterion for being an aristocrat, strictly enforced by funds bearing this moniker, might be viewed as effectively locking companies into automatic dividend increases, though this should be a periodic choice for corporate boards rather than a foregone conclusion.
Dividend aristocrats have generally acquired an aura of venerability, sustaining the widespread assumption that there are good reasons to invest in them aside from dividends. These companies must all be financially strong if they can afford to raise dividends every year, many investors assume, thinking: Otherwise, how could they afford to do so?
For some of these aristocrats, this reputation is well deserved — but for some others, the record shows, not at all. Like some literal aristocrats with noble titles but withering finances, some of these companies are apparently keeping up pretenses by chronically giving shareholders dividend increases that, as their financials clearly show, they can’t afford.
So revered are dividend aristocrats that admiring investors wouldn’t expect any of them to give up their titles by cutting dividends. But recently, two of them have defied expectations by doing just that. In April, 3M and Leggett & Platt (NYSE:LEG) announced cuts.
3M announced that its dividend this year will be about 40% of adjusted free cash flow, which is expected to result in a year-over-year cut. This is a big change for 3M, which has paid a dividend for 100 years and has increased it annually for the last 64. Leggett & Platt, which manufactures engineered components and products, announced an annual dividend cut after 52 straight years of increases.
Earlier this year, another aristocrat, Walgreens Boots Alliance (NASDAQ:WBA), cut its quarterly dividend in half, which will likely mean a reduced annual payout. As of May 20, when the Dow had just passed a new high of 40,000, shares of this DJIA company (added to the index in 2018) were $1 off their 25-year low. In hindsight, this raises some serious questions about the advisability of the company’s having raised dividends long enough to achieve noble status.
It’s probably no coincidence that some companies are cutting dividends during this period of elevated interest rates, which make corporate debt loads all the more burdensome. In this rate environment, which will likely persist into 2025, it wouldn’t be surprising if more dividend aristocrats end up slashing dividend payouts this year.
Due Diligence
Investors who exercise sufficient due diligence in researching stocks may be able to identify some future ex-aristocrats. Thus, those who have gone wrong by investing purely or largely for dividends might be able to assure that, as The Who pledged in the title and lyrics of their classic 1971 song, they “won’t get fooled again.”
Investors who do their homework may come to question whether some aristocrats should be paying dividends at all, much less increasing them annually.
This research should be conducted with the rationale for dividends in mind. Dividends are an annual or quarterly choice made by the board of directors on what to do with profits. Instead of electing to pay a dividend, much less an increasing one, boards may decide to put more cash back into the business or pay down debt.
Investors enamored of the aristocrat category in general might want to become familiar with the performance of ProShares S&P 500 Dividend Aristocrat ETF (NOBL), which holds shares of about 50 such companies. Year to date as of May 21, NOBL was up 4.4%, compared with 11.5% for the S&P 500. For one year, NOBL was up 8.4%, versus 26.6% for the S&P 500 and for three years, 7.8%, versus 27.6%.
An inherent problem for some of NOBL’s holdings is that they’ve burdened themselves with an obligation to raise dividends every year — in good years and bad.
Bristol-Myers Squibb (NYSE:BMY)
A prime example is Bristol-Myers Squibb Co. (BMY). While raising dividends every year, this well-known company, headquartered in Princeton, N.J., has sometimes paid out dividends greater than its earnings for a given period, despite being as financially strapped as some parents paying their kids’ tuition at Princeton University.
BMY’s financial condition is plain for all to see. Currently, the company is on track to earn less than a quarter of its dividend this year — a $2.40 dividend against 56 cents in EPS. But BMY keeps paying this rich dividend as though everything were hunky-dory. The company hasn’t even hinted at a dividend cut, though in the pharma industry, it can cost more than $1 billion to bring a single drug to market from inception.
More appropriate corporate governance for such companies would be a floating dividend policy — pay it when you can, raise it when you can — as practiced by many public companies unabashedly lacking in aristocratic aspirations.
But instead, with a tangible book value of minus $30 billion and long-term debt of about $57 billion, BMY is acting like a fallen European aristocrat going into debt keeping up the grand family estate rather than moving to a more modest abode. Companies like BMY could salvage some fiscal credibility by following the lead of 3M and Leggett & Platt.
One goal of being a dividend aristocrat is to attract investment, boosting the stock price, but this strategy hasn’t been working for BMY. After the company disclosed to analysts in early April that it would barely break even this year, the stock rapidly fell from $55 to $44 in mid-May—the same price as in October 1997, when the Dow was at 8,000.
Companies in the habit of paying dividends they can’t afford are like individuals projecting a misleading image of wealth. Texans sometimes refer to such people as being “all hat and no cattle.”
More investors would do well to resist the temptation to buy shares of companies just because they have big dividend hats, and focus more on the cattle of their financial fitness.
Robert C. Auer is the founder of SBAuer Funds, LLC, based in Indianapolis, and has served as the Senior Portfolio Manager for the Auer Growth Fund since its inception in 2007. Previously, he served as Vice President of Investments for Morgan Stanley.
Companies mentioned in this article may be held by Auer Funds, LLC, or related persons.