#1 – Focus on dividend-paying companies
When I start looking at a company I like to get the ball rolling with a few simple checks on its dividend history and the earnings upon which those dividends depend. Although defensive value investing isn’t necessarily an income-focused approach, dividends do make up the backbone of the strategy.
To make sure we’re on the same page, here’s a definition:
There are several reasons why dividends are central to my approach and why the process of analysing a company begins with them. The most important reasons are:
1) Efficient capital allocation
A company should only retain cash generated from its operations if that cash is required to run the existing business, or if that cash can be invested (in new factories or new equipment for example) at an attractive rate of return. Cash that cannot be deployed in those ways should be returned to shareholders as a dividend.
With companies that don’t pay a dividend there is a greater risk that the retained cash will be used to expand the CEO’s empire rather than maximise returns for shareholders.
2) Commitment and accountability
Companies that have a progressive dividend policy have made a promise to investors that they will maintain or grow the dividend each year. This provides a public and very concrete goal for the company’s management to achieve. Of course this promise can be broken, but on average dividend commitments do help companies to perform better.
3) A helpful yardstick
A progressive dividend gives investors a gauge for the long-term progress of a company. While earnings and to some extent revenues bounce around from year to year, a progressive dividend can give a good indication of the underlying growth rate of a company.
4) A cash income
Perhaps the most obvious benefit of dividends is that they are a form of cash income. For those investors who are after an income, either today or in the future, dividends are an excellent way to receive that income without having to sell any shares.
Why was Ben Graham interested in “a long record of continuous dividend payments”?
The logic behind Ben Graham’s rule on dividends (quoted at the top of the page) is simple. If investors want to buy companies that are likely to pay a consistent dividend in the future, the best place to find such companies is among those that have paid a consistent dividend in the past.
That’s why I look for companies with a long and unbroken record of dividend payments, and my definition of a “long record” is at least ten years. This leads me to the first of many rules of thumb that make up the defensive value approach.
I don’t mind the odd missing interim or final dividend, as long as some sort of dividend was paid in every year. If there is a year in that ten year period in which no dividends were paid then the company goes straight into my metaphorical waste paper bin.
It is important to remember that a consistent dividend record is not a magic bullet, because dividend payments are not guaranteed. No matter how good a company’s track record, you can never be sure that the dividend won’t be cut or suspended at some point in the next few years.
The banking crisis of 2007-2009 was a good example of this. A whole group of companies that were thought to be safe – i.e. the big banks – turned out to be anything but. The banks suspended their dividends, in some cases for several years.
Unfortunately, dividend cuts are a fact of life. If you invest for long enough in dividend-paying companies you will see a dividend cut in your portfolio at some point. However, this is not a reason to abandon the approach.
Instead, the risks of seeing a dividend cut can be reduced by looking at a range of additional factors such as profitability, debt levels and cyclicality. As a last line of defence, your portfolio should be widely diversified across many different companies, which will reduce the impact of the occasional dividend cut when it occurs (we’ll cover each of these points in detail later on).
Finding ten years of data
There are various ways you can get hold of a company’s financial data for the past ten years. The obvious place to look would be the annual results, but that approach is very time consuming and any per share data, such as dividend per share, will not have been adjusted for share splits or share consolidations.
Share splits and consolidations basically change the number of shares a company has and the price of each share, but they don’t affect the value of each shareholder’s holdings. However, they do affect per share figures such as dividends and earnings per share, which means that per share figures from older annual and interim results have to be adjusted to take account of the change.
You could do this by hand, but my preferred approach is to get the ten years of data from a provider such as Morningstar or SharePad, at least initially, and to supplement that with the company’s official results documents if I decide to get into a more detailed analysis.
From now on I’ll assume you have access to all the required financial data, so let’s move on and analyse the dividend record of a company I purchased some years ago.
The dividend history of Petrofac (PFC)
Petrofac is a FTSE 250-listed company operating in the Oil Equipment, Services & Distribution sector. It is involved in the construction, maintenance and operation of oil and gas facilities worldwide. Up to its 2014 annual results it had the dividend record shown in Table 1.1.
|Year||Dividends (pence per share (p)|
Table 1.1: Petrofac’s dividend record through ten years to 2014
Looking for dividend payments in every one of the last ten years is a pretty simple test. Either a company made a dividend payment in every year or it didn’t. In Petrofac’s case it did, so at this stage it would still be a viable investment candidate.
Looking for a long history of positive earnings
Of course, dividends don’t appear out of thin air. A company first has to generate revenues and profits because without profits there can be no sustainable dividends, and without revenues there can be no profits.
Let’s nail down some earnings-related terminology:
Personally I use normalised EPS because it is standardised and gives me a better picture of how the underlying company is performing. When I mention earnings or earnings per share throughout the rest of the book you should assume I mean the normalised version. If you are going to get your accounting data from each company’s annual reports rather than from investment websites you will have to use basic or adjusted earnings per share in place of the normalised version.
When I look at a company’s earnings I’m looking for a long history of profits (i.e. positive earnings per share), rather than a company which generates losses (i.e. negative earnings per share) every few years. However, unlike my dividend rule of thumb which says that no company will be considered if it failed to pay a dividend in one year, I don’t automatically rule out companies that made a loss at some point in the last ten years.
My thinking here is that while a good company should be able to pay a dividend even when times are tough, the same isn’t necessarily true for earnings. With dividends, a good company will have a cash buffer that it can dip into occasionally, but no such buffer exists for earnings. This means that sometimes even very good companies can make the occasional loss.
Having said that, a company which regularly loses money is unlikely to be a suitable investment. I don’t want to be overly restrictive, so I’m willing to accept companies that occasionally make losses, as long as the losses are not too frequent or too large.
Overall, companies should have earned more in the last ten years than they paid out in dividends. That at least gives me some confidence that their dividend is sustainable.
Calculating the ten-year dividend cover ratio
The ratio between earnings and dividends is called dividend cover. A dividend cover of more than one means that earnings for the period exceeded dividends paid. Most investors calculate dividend cover for the latest year only, but as with the dividend track record, I prefer to measure it over a ten-year period. The calculation for ten-year dividend cover is:
ten-year dividend cover = ten-year total EPS / ten-year total DPS
The first rule of thumb for earnings is therefore:
Let’s turn to the real world and see how these concepts can be applied to another of my recent holdings.
Mitie Group’s long-term dividend cover
Mitie is a FTSE 250-listed company operating in the Support Services sector. Its main business is the supply of outsourced services to other companies, such as cleaning, security and pest control. It has paid a dividend in every one of the last ten years, so it’s definitely a candidate for further analysis.
To check its long-term dividend cover we’ll need its earnings and dividends for the last ten years, which you can see in Table 1.2.
|Year||Normalised earnings per share (p)||Dividends per share (p)|
Table 1.2: Mitie’s dividends and earnings per share, 2005-2014
Mitie’s earnings record shows an unbroken string of profits during the period. Although I’m not put off by the occasional loss, I do prefer to see unbroken profits like Mitie’s.
As for the company’s ten-year dividend cover, it’s clear just from looking at the numbers that the dividend is well covered in every year, so obviously the ratio is above 1. However, I still think it’s worth calculating the ratio anyway as it’s a good habit to get into. For Mitie the calculation goes like this:
ten-year dividend per share total = 71.5p ten-year earnings per share total = 167.89p ten-year dividend cover = 167.89p / 71.5p = 2.3
Mitie’s ten-year dividend cover over the ten years to 2014 was 2.3. That’s obviously well above my minimum of 1, so Mitie easily ticks that particular box.
In the next lesson we’ll turn to the subject of measuring a company’s growth, but first here’s a quick summary of the rules we have covered so far.
This course is intended to inform and educate private investors. It does not provide financial advice. It should not be relied upon in isolation before making any investment decisions. You should always do your own research and iIf you are unsure about the suitability of an investment you should consult with a regulated financial adviser. Read the full disclaimer here.