When the cash machine is broke

By Shane Leonard on Oct 10, 2015

This post first appeared on Medium

When the cash machine is broke

The dangers of buying a stock whose earnings are less than its dividends

There is no data on the future. And no “system” works consistently in the stock market. This keeps the professionals guessing and often scares the rest of us. But, as Warren Buffett is at pains to repeat:

The value of a business is the cash it’s going to produce in the future.

Ignore the cash flow potential of a business at your peril. Perhaps the brightest signal on cash flows are the dividends you get. When dividends are higher than earnings

Dividends can only be paid out of profit. So it’s rare to see dividends that are higher than earnings, but it does happen.

In the case where the board is giving a special dividend, there is rarely a case for alarm. In fact, the market usually cheers the extra cash payment.

But if earnings have fallen, albeit temporarily, and the board decides not to cut the dividend, there may be cause to sell out. It’s a warning signal. Not fool proof, but it’s a flag all the same.

A warning? Why?

It all comes down to the word temporary. Look what the recent collapse in oil prices has done to the earnings of the oil majors. Is this temporary or permanent?

Earnings estimates for year to December 2015, today versus a year ago.

If the hit to earnings is temporary, then a company’s board of directors may decide to keep the dividend payment flat on the previous year. Even if forecast earnings fall below dividends, the board can dip into the company’s reserves to maintain the dividend. If they decide to live with a dividend / earnings imbalance, the signal to shareholders and the stock market is one of confidence. Confidence that the long-term cash potential of the company is intact.

Sticking with the example of the oil majors. Only one of them, Chevron, is in the dividend danger zone. Earnings forecasts for 2015 are down 71% to $3.30 a share. But the expected dividend for 2015 is $4.31 a share, which exceeds earnings.

But with earnings forecast to expand again in 2016, to $4.45 a share, the dividend / earnings imbalance looks temporary. At least that is the forecast of the professionals on Wall Street.

But what if the forecasts are wrong?

If a temporary fall in earnings turns out to be permanent, then the impact is usually bad. Obvious, you might say? Yes, it is simple, the future cash flow potential has fallen.

The problem, though, is the speed with which the stock market reacts. It’s rare that earnings forecasts are cut before the stock falls. Usually the stock price falls before the professionals on Wall Street get to change their forecasts. Similarly, by the time you realise that the dividend is going to be cut, and that the fall in earnings isn’t temporary, it’s also too late. You’d be:

Shutting the stable door after the horse has bolted.

So what are you to do? Be vigilant. If the fundamentals of a business you’ve invested in start to get worse, reconsider your investment. It’s not a must sell, but you need to ask yourself one simple, but troubling, question:

If I didn’t own this stock today, would I buy it?

If the answer is no, then why on earth do you still own it? Don’t get emotionally attached to any investment.

Let’s run the numbers!

I ran the numbers for UK stocks back in March. There were 7 companies, worth over $1 billion, that were forecast to pay higher dividends than earnings. Two were giants, BP and Vodafone. Here’s what the picture looked like at the time.

Roll forward 6 months, and what’s happened to their earnings and dividend forecasts? Six of the seven companies have seen the forecast earnings decline with four of them seeing forecast dividends decline.

Did the changes in forecasts impact their prices? Yes, performance was universally negative.

We need to put this into the context of the stock market, though. In the UK, the large-cap index FTSE 100 is off 14% over the same period. And the mid-cap index FTSE 250 is off 4%.

It’s just a flag, not a “system”

So yes, the dividend / earnings imbalance was a flag, but in some cases (CWC, TalkTalk and Vodafone) the stocks have performed reasonably when compared to the market. How can that be?

Share prices are driven by two factors: fundamentals and sentiment. It’s entirely possible for the fundamentals of a business to get worse, but for sentiment to not change, or even improve. Sentiment can be a powerful driver of stock prices in the short term. Booms and busts being extreme examples. To quote Warren Buffett’s mentor, Benjamin Graham:

In the short run, the market is a voting machine but in the long run it is a weighing machine.

So yes, it’s a flag that something bad may happen. But like any rule of thumb, there are many times it doesn’t hold. Especially in the short term.

Forget the past, what about today?

I hate price charts, as they tell me what I should have done 3 months ago, not what I should do today. Equally, you can accuse me of telling you about the fall of 7 major UK companies, after the fact. Your criticism is valid.

So why don’t we run the numbers today? Both US and UK.

I doubt anyone’s surprised to see a mining and an oil stock on the list. Though seeing a pharma and an insurance one is a little more mystifying.

The US list is oils heavy. Plus, given the size of the US stock market, I’ve only posted the 12 stocks with a value over $25 billion. To see the full list of 76 stocks over $5 billion with a dividend / earnings imbalance, please click this link for the data.

US companies with market value over $25 billion with forecast dividend / earnings imbalance, 24th Sept

And, what should you do?

We don’t make recommendations or provide advice. We are highlighting a rule of thumb, a cautionary flag. So let’s roll forward six months, and see how the 18 companies above deal with their imbalance! I suspect it’s be a mixed bag.

And, if you are scratching your head and wondering what you should do? Well… be vigilant. To quote the economist John Maynard Keynes:

When the facts change, I change my mind. What do you do?

So if the fundamentals for any investment you’ve made change, it’ll be time to think again.

Please drop me a message @shaneleonard121 or the full team @stockflare.

Shane Leonard

Managing Director