Don't Get Burned When a Stock Cuts Its Dividend

If you invest for dividends, you probably got a raise in 2017. More than 300 com­panies in Standard & Poor’s 500-stock index hiked their payout during the year, with increases averaging 11.5%. Yet investors in General Electric (symbol GE, $18) got a lump of coal just before the holidays as the firm slashed its quarterly dividend by 50% on November 13.

The cut wasn’t a surprise, given the firm’s struggles. But it raises questions: If a bellwether such as GE can’t sustain its payout in a strong economy, what other dividends may be on the chopping block? And how can you spot the next GE?

GE’s dividend cut looks like an outlier. The company was one of just 10 firms in the S&P 500 to trim or suspend its dividend in 2017 (through December 8). GE’s profits have been sliding for years, and its cash flow in 2017 was “horrible,” new CEO John Flannery said recently. His remedy: Stanch the bleeding by cutting GE’s payout.

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Yet most big firms aren’t in bad shape. Corporate profits are rising briskly, overall. And analysts expect companies in the S&P 500 to increase their payouts by an average of 10% in 2018. Enactment of a tax overhaul could boost payouts further. “There’s nothing systemically wrong with the economy or corporate profits that would lead to lots of dividend cuts,” says market strategist Ed Yardeni, of Yardeni Research.

Sidestep trouble. Still, dividend land mines may be hiding just below the surface of some stocks, says Sam Stovall, chief strategist of research firm CFRA. Avoid them by sticking with solidly profitable firms with a long history of dividend growth. Companies such as 3M (MMM, $238) and Johnson & Johnson (JNJ, $141) fit the bill. Both are in the Kiplinger Dividend 15, the list of our favorite dividend-paying stocks (see The Kiplinger Dividend 15: Our Favorite Dividend-Paying Stocks).

Look for stocks with moderate payout ratios (dividends as a percentage of earnings). Note that slow-growing businesses with stable cash flows, such as phone companies and utilities, can maintain higher ratios than firms spending more to expand or those with unpredictable income.

But in general, a low payout ratio is a sign that your dividend is secure. Banks and other financial stocks now have the lowest payout ratios of any industry, averaging 30%, followed by health care companies (34%) and technology firms (39%). All are below the average 43% payout ratio for the S&P 500.

Red flags that a dividend may not be sustainable include deteriorating earnings and ballooning debt on the balance sheet. Investors may also want to monitor free cash flow, which can be a better gauge of a dividend’s cash cushion than a com­pany’s earnings. Earnings can be inflated by one-time gains or other accounting adjustments, but positive free cash flow means that a company has spent what it needs to maintain its business and has cash left over—ideally enough to cover its payout.

Beware of sharply rising yields, too. Shares of Macy’s (M) now yield nearly 6%. Yet, like other struggling retailers, its sales and profits are falling, putting its dividend at risk. Another dividend that looks dicey is that of phone-and-cable firm CenturyLink (CTL). The shares yield 15%, but CenturyLink isn’t close to covering its payout with earnings or free cash flow.

Investing in a diversified basket of dividend stocks lessens the risk that you’ll be undone by the misfortunes of any single company. Consider Schwab US Dividend Equity (SCHD, $51), an exchange-traded fund in the Kiplinger ETF 20, the list of our favorite ETFs. Or check out Vanguard Equity Income (VEIPX) or T. Rowe Price Dividend Growth (PRDGX). Both are in the Kiplinger 25 list of our favorite funds.