How to Ensure Your Dividends Will Survive Austerity

Brinksmanship or buffoonery? We’ll know soon enough which better describes the budget debate in Washington, as the deadline for averting the prospective package of spending cuts and tax increases edges closer.

Financial media remain in overdrive hyping the threat of a “fiscal cliff,” in which sudden austerity immediately triggers a recession and market meltdown. In reality, failure to alter the 2011 budget package that avoided a first-ever US government default would amount to more of a slow bleed as far as growth is concerned.

Companies doing direct business with the federal government would feel the pinch first, with the affected ranging from defense contractors to Medicare service providers. By mid-January, however, Americans would start to see more money come out of their paychecks, from both higher income tax rates and increased Social Security levies.

Businesses have, of course, had several months to prepare for across-the-board cuts in federal spending. And we’re likely to see the result in fourth quarter gross domestic product (GDP) growth that sharply lags the third quarter’s relatively robust 3.1 percent rate.

Some sectors will be harder hit than others. Wind power tax credits, for example, are set to expire Jan. 1. That’s triggered a rush to complete projects by the end of this year. In fact, as of Nov. 30, new wind turbine construction for 2012 was actually running ahead of new natural gas generation.

Beyond that, however, manufacturers such as General Electric (NYSE: GE) and Denmark’s Vestas Wind Systems (Denmark: VWS, OTC: VWSYF) are already prepared for US activity to screech to a halt. In fact, Vestas’ CEO has projected a catastrophic 80 percent contraction of the US wind market and is downsizing operations by 3,000 jobs.

There is real uncertainty, however, regarding how higher taxes will affect consumer spending once disposable income contracts. Though consumer confidence has apparently waned as of late, spending is by all accounts within the realm of expectations to date.

The Same Result

My view has been that Congress and the White House would reach a deal on the budget that imposes austerity less drastically than the tax increases and spending cuts that would otherwise take effect. And that’s still my expectation, despite the inability of House Speaker John Boehner to unite Republicans this week and an apparent breakdown of talks.

Whether there’s a deal this month, next month or not at all, however, the result will still be austerity. And whether it’s phased in or slams down all at once, there will be an impact on the economy and investment markets.

The great fear of many investors is the lack of a deal on the so-called “fiscal cliff” at the outset of the new year will incite a full-scale panic when markets re-open on Jan. 2. Given that emotional human beings are what make markets, that kind of reaction is certainly possible. And we’ve already seen some big investors get at least a bit more cautious this week, with capital flowing back to what’s still considered the currency of last resort: the US dollar.

The greater danger to income investors, however, is what happens later, as austerity starts to affect companies’ profits–and consequently their ability to keep paying dividends and interest. As the 2008-09 crash proved, dividend-paying stocks will recover even the worst near-term losses, so long as their underlying businesses stay healthy and payouts remain secure.

But the same isn’t true when companies truly weaken and in fact slash or eliminate dividends. And when that does happen, the wise move is always to cut and run.

Believe it or not, there are reasons to be hopeful. First, the markets have been anticipating austerity in Washington in one form or another for quite some time. Even if the fiscal cliff proves as fearsome as talking heads proclaim, going over it would not be the sudden shock that the collapse of Lehman was in 2008. That blow to confidence more than anything else set off that year’s wave of panic, and only decisive and controversial action to bail out the banks quelled it.

Second, also in stark contrast to pre-crash 2008, investors, businesses, consumers and governments are definitely not leaning in a bullish direction. Rather, Americans have spent the four years since the last crash reducing exposure to future calamities.

Corporations today have record amounts of cash on their books. And only a handful of weaker and more aggressive outfits have significant near-term debt refinancing requirements that could expose them to tightened credit conditions.

As for US households, despite sluggish or non-existent wage growth in recent years, the Federal Reserve reports total debt as a percentage of annual income has dropped to 103 percent. That’s the lowest level in nearly a decade. The cost of servicing that debt, meanwhile, is at roughly 65 percent of income, the lowest level since the early 1990s.

That’s a night-and-day difference with pre-crash 2008, when both debt-to-income and debt service ratios were peaking at nearly 125 percent and 110 percent, respectively. And while these levels certainly don’t rule out another bear market for stocks in 2013, debt service-to-income is commensurate with the early 1990s and early 1980s, at the start of major multi-year bull markets and years of economic expansion.

The early 1980s, of course, were hardly a time of austerity. Rather, President Ronald Reagan’s administration launched one of the most expansionary fiscal policies in history to help the country emerge from recession. That included an unprecedented peacetime explosion of military spending along with dramatic tax cuts. The early 1990s, however, began with an attempt by President Clinton to balance future federal budgets, principally with tax increases.

Clinton’s move was hardly as contractionary as this batch of tax increases and spending cuts are projected to be, though it was every bit as controversial at the time. But sharply lower debt does suggest that sudden austerity from budget deal failure may not be quite the catastrophe many fear.

And there’s still the possibility cooler heads will prevail in Washington. In fact, if the current bluster actually morphs into a lasting budget deal, diminished uncertainty on spending and taxes should at last unlock the investment potential of all that cash on corporate balance sheets.

Dividend Checklist

That’s my basic rationale for why current circumstances–however scary–don’t justify abandoning the market now, particularly with alternatives to dividend-paying stocks yielding such a pittance.

That doesn’t mean, however, that some companies won’t falter in the coming year, especially with the big picture so cloudy. And if the worst case does become reality, this brief checklist will likely prove critical in determining whether companies have what it takes to endure:

Revenue Reliability. Have your holdings’ revenue and dividends held up during past downturns such as 2008? If so, that’s a pretty good reason to be confident they will survive the pressures of austerity in 2013. Examples of dividend-paying sectors with very reliable revenues include regulated electric, gas and water utilities, fee-generating energy midstream companies such as pipelines, and big US telecoms.

Note that energy producers by and large do not produce reliable revenue, due to exposure to volatile energy prices. Exceptions include super oils–which power through downturns thanks to superior scale–and companies that heavily hedge future sales such as master limited partnership (MLP) Linn Energy LLC (NSDQ: LINE).

Low Payout Ratio. Too many investors assume that a company with a low payout ratio–dividends as a percentage of earnings–will always have a safe dividend. That’s only true, however, if the payout ratio is calculated on the basis of recurring income, i.e., excluding any one-time gains, and is using the most relevant measure of profits.

For many companies, that’s a number sometimes referred to as distributable cash flow (DCF) or funds from operations (FFO), which compares the payout to the company’s ability to fund it with actual cash. In addition, payout ratios are only relevant when compared with the revenue reliability of a particular sector. A regulated utility with a payout ratio of 60 percent, for example, is a much safer bet than a copper producer with a payout ratio of 30 percent–mainly because its revenue doesn’t fluctuate with commodity price volatility.

Debt. As with payout ratios, too many investors assume one measurement of financial strength can be applied for every company, usually some comparison of total debt to assets or shareholders’ equity. Those are interesting metrics, but only if you put them in context with companies’ revenue reliability. Mainly, a regulated utility with a debt-to-assets ratio of 50 percent is far safer than an energy producer with an equal ratio.

And debt-to-assets is not the best measure of exposure to tightened credit conditions such as occurred in 2008. Rather, the key red flag is a large amount of debt to be refinanced–either bond maturities or credit agreements–in the next 12 months, relative to the size of the company. Companies should have total maturing debt in 2013 at no more than a few percentage points of market capitalization, or preferably at zero. The greater the amount of maturing debt, the greater the cost to companies forced to refinance in tough times.

Odds are, not every company you own is going to measure up on all of these counts as much as you’d prefer. And there’s nothing wrong with holding a piece of your portfolios in companies with less reliable revenue, relatively high payout ratios or even large amounts of debt to refinance in 2013.

It is important, however, to recognize that these qualities would expose companies’ earnings and dividends if austerity takes a real bite out of the US economy next year. And as a result, risk to their dividends is greater, and their stocks could therefore prove more volatile than usual.

As long as your portfolio is well diversified and balanced among high-quality companies across a range of sectors–and you don’t overweight holdings either intentionally or inadvertently–a blow-up in a single stock won’t cause a permanent loss. If you do own companies whose operations are at risk to austerity, make sure they’re held in the context of a balanced portfolio. That’s always the key to making it through adverse market conditions with your long-term wealth-building capability intact.

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1. 

   Reply Carl McLain December 22, 2012 at 1:19 AM EDT

   I have, like many other investors, lost most of my portfolio over the last 4 years due to bad investments. I have approximately $100k left to invest but it has to count and I need a good dividend to supplement my income. Please let me know if and how what you have to offer can or will help me. Thank You.
2. 

   Reply Marilyn NIelson December 25, 2012 at 4:45 PM EDT

   Since I signed up for the newsletter? MLP, I no longer receive Roger’s Friday emails. I would appreciate getting those again and, tell me how information regarding the MLPs is sent. Nothing in the mail, so???
   Thanks,
   Marilyn Nielson
   Merry Chrestmas

   • 

     Reply Andrea December 26, 2012 at 10:27 AM EDT

     Dear Ms. Nielson,

     MLP is delivered via email, as is Roger’s weekly Utility & Income. Sometimes a piece of mail may inadvertently be placed in a SPAM folder which is an indication to your Internet Service Provider that you do not wish to receive the mail. If this happened, the mail will not be delivered to your mailbox.

     Please call Subscriber Services at 1-800-832-2330 with your personal information so we may track your deliveries.

     Sincerely,
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3. 

   Reply Jim Pearce December 26, 2012 at 10:23 AM EDT

   Carl,

   We have two publications that cover good dividend paying stocks; Utility Forecaster, and MLP Profits. I’d be happy to discuss either one or both with you if you are interested. Thank you.

   Jim Pearce
   Investing Daily Wealth Society Director
   703-905-4571