Sunday, April 15, 2012

How to Identify Dividend Prodigal Sons

Dividend Aristocrats...Dividend Achievers...Dividend Champions. We all know what type of companies are on those lists -- companies that have raised their dividends each year without fail for decades. There's certainly a lot to be said for those companies as they've obviously been doing something right and they almost assuredly have solid competitive advantages. In short, they're a passive dividend investor's dream...when they can be purchased for the right price.

The problem is that investor assets have flooded into dividend-focused ETFs that own these type of stocks. For instance, the SPDR S&P US Dividend Aristocrats ETF raised almost $100m days after it Europe.

As a result of this heightened investor interest in dividend-paying stocks with impeccable track records, the cream-of-the crop stocks may not be great buys right now. Instead, if you're seeking dividend-paying stocks that have a better chance of being undervalued right now, you should also consider looking into dividend-paying stocks that I'll call "prodigal sons". These are stocks that once had sterling dividend track records but fell from grace during the financial crisis by cutting their payouts and are now in the process of rebuilding their dividend reputation.

Hundreds of companies cut their payouts during the financial crisis, but not all of them cut for the same reasons. Some were forced to by regulators (big banks), some levered up and made silly acquisitions at the wrong time, and some simply got caught paying out more than they could afford. The fact that they cut their payouts shouldn't be forgotten, but they shouldn't be written off completely, either. Some of them may be back on the road to redemption.

But how do we begin to separate the Prodigal Sons from the repeat offenders?

First, determine why the company cut its dividend during the financial crisis. Take a look at its financial statements in 2008 and 2009 and read the press release and management comments surrounding the dividend cut announcement. Did the company have the financial resources to continue paying and opportunistically seized the opportunity to reset its payout to a less burdensome level? Did it make some big investments at the wrong time that -- in hindsight -- put the company in a tough spot going into the recession? In some cases, companies should be let off the hook a bit for making the right investments at the wrong time.

Who was running the company when the cuts were announced? Is it the same team today? If it's the same team, look to see if they've learned their lesson -- look for cost cuts, an improved balance sheet, a more focused growth strategy, better returns on capital and equity, and renewed dividend hikes since the nadir. If the team has changed, what is their strategy and how does the dividend fit into it?

Has the company explicitly addressed the future of its dividend? If the company has realigned its dividend policy to be more sustainable (a lower payout ratio/higher cover), that's a positive sign. A company that's hiked its dividend each year since the cut is another encouraging sign. Look for management's comments on the dividend in conference call transcripts and in annual reports. Companies often address their priorities for free cash flow in conference calls or investor presentations -- is the dividend one of the top priorities?

What was the company's dividend track record prior to the cut? A company that increased its payout for 15 years prior to the cut, for instance, likely means that the dividend is part of the corporate culture and management might be eager to regain its reputation as a steady payer.

All this is to say that some of the best longer-term dividend ideas right now might be found in the group of Prodigal Sons. They should be approached with caution and they'll take more research effort, but the payoffs may be worth it.