The Case for Dividend Quality: A Multi-Faceted Approach

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” — JOHN D. ROCKEFELLER

Rockefeller’s sentiment above remains true for many investors. For decades, dividend income has been a crucial component of a stock investor’s total return, often trumping capital appreciation in volatile markets. In this recent environment of falling yields on bonds with interest rates at or near zero, dividends are especially valued. That is when income-seeking investors start to include dividends in their search for yield to meet their financial goals. Blindly focusing on yield, however, could be dangerous to an investment portfolio’s health. A seemingly generous dividend yield may actually signify a weak share price tied to negative news not yet revealed in the quarterly dividend. Yields for a current year are often estimated using the previous year’s dividend yield or by taking the latest quarterly yield, multiplying by four and dividing by the current share price. This explains why investors in dividend stocks must be confident the dividend being paid is sustainable. In other words, make sure the payout is well covered and the company can grow it over time.

FLAWED DIVIDEND STRATEGIES MAY CLOUD INVESTOR JUDGEMENT

Over the years, investors have applied various strategies to avoid overpaying for dividend yield. First, if a company has paid dividends over a long time period (often referred to as longevity), investors trust it will likely continue paying a dividend in the future.2 The alternative, focusing on a dividend’s growth over time, views a reduction in the current distribution as a red flag that the dividend may be pared back further in the future.

There are flaws in both strategies:

Reacting to a reduced dividend after it occurs results in holding the dividend-paying security until the next rebalance, potentially after the stock price has absorbed the negative dividend news;

In order to evaluate a company, a long history of dividend payouts (often a decade or more) may be required, which means newer dividend payers are excluded from consideration; and

Recent changes in the macro environment that could affect the company’s ability to maintain or grow its dividend may be downplayed.

A third strategy is using the payout ratio – the dividend per share divided by earnings per share – to evaluate a dividend payer’s financial health. While correct directionally, the payout ratio strategy also possesses several drawbacks. It looks only at the dividend in reference to “the bottom line,” so it may not tell the full story. For instance, it gives no guidance about a company’s flexibility in managing its income nor does it consider any competitive advantages to protect the firm during periods of market distress. More importantly, it evaluates the distribution in terms of accounting income and not actual cash flow. Further, a singular focus on payout ratios may eliminate companies in mature industries that return most of their income to shareholders but are financially stable and well-positioned to maintain that dividend rate.

A BETTER APPROACH – FOCUSING ON THE CORE FINANCIAL HEALTH OF THE DIVIDEND-PAYING COMPANY

So, how can investors judge a “sustainable” yield? Measuring a company’s core financial health makes it possible to evaluate whether it may increase (or need to decrease) its future dividends. With this approach, the reliance on publicly available financial data means new dividend payers can be evaluated similarly to stocks that have paid dividends for decades. By using several lenses to evaluate financial health, an investor can gain a strong sense of how well-positioned a dividend-paying company is for success, and how protected future dividends are under current market and economic environments.

FlexShares’ multi-faceted Dividend Quality Score (DQS) examines companies using three lenses in its Dividend Quality Index methodology (see Figure 1):

Management efficiency is a quantitative evaluation of a firm’s deployment of capital as well as its financing decisions. Research finds firms that aggressively pursue capital expenditures and additional financing lose flexibility in both advantageous and challenging portions of the market cycle.

Profitability scores a firm’s relative competitive advantage across several different metrics. Firms with wider margins are better positioned to grow and maintain their dividends than firms with slimmer margins.

Cash flow assesses the liquidity levels of the company. A firm that cannot meet its debt obligations and day-to-day liquidity needs will struggle to maintain its dividend level.

The DQS score evaluates dividend-paying equities across all these lenses and ranks companies on a sector basis. (For international dividend payers, the DQS score evaluates firms on both a regional and sector basis.) This not only helps ensure an “apples-to-apples” comparison – profiling similar firms against each other – it also identifies quality companies in every sector (and country for international markets), supporting diversification even in the initial construction process.

MAXIMIZING QUALITY AND YIELD

FlexShares’ DQS process is designed to maximize quality and yield while putting several diversification controls into effect. The strategy strives to harness dividend quality and yield through its selection and weighting process. Non-dividend payers are eliminated from the universe of large cap equities, as are the lowest 20 percent of companies in the DQS ranking.

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1 Source: Investopedia http://www.investopedia.com/terms/d/dividendyield.asp
2 Dividends represent past performance, and there is no guarantee they will continue to be paid.