By Philip van Doorn
Many U.S. stocks are still trying to claw their way out of a hole caused by the global pandemic. And for income investors, dividend reductions have been the unkindest cut of all.
A decrease in dividend payouts slashes investors’ income and also hurts share prices — a double whammy.
Bill McMahon, chief investment officer for active strategies at Charles Schwab Corp., talked to MarketWatch about how his team selects dividend stocks and gave pointers on how they run initial screens, potentially helping investors at home.
McMahon has long been a proponent of dividend-stock investing — specifically, companies that appear likely to raise their payouts steadily, regardless of their current dividend yields. A way to measure a company’s ability to pay dividends is to look at free cash flow yields.
A company’s free cash flow (FCF) is its remaining cash flow after planned capital expenditures. It is money that can be used for any corporate purpose, including expansion through acquisitions or increased capital spending, as well as share buybacks and dividend increases.
A company’s free cash flow yield can be compared with its dividend yield to see if there is “headroom” for a dividend increase or the deployment of cash in some other manner friendly to shareholders. The headroom is critically important to McMahon because it is a signal that a company’s management is free to take action to benefit shareholders.
During 2020, the partial shutdown of the economy that began in March has grossly affected many companies’ free cash flow. So McMahon recommends not only looking at trailing free cash flow yields, but forward free cash flow yields as well. His research team makes its own estimates, but we can use consensus estimates among analysts polled by FactSet.
This may sound like a value strategy. McMahon recommends investors take a “balanced approach between value-oriented and growth-oriented names.”
On the growth side, he cited Microsoft Corp. /zigman2/quotes/207732364/composite MSFT +1.00% during an interview. The shares have a dividend yield of only 1.04%. However, McMahon sees the company as “a beneficiary of lockdowns,” accelerating its “multiyear trend toward moving more and more technology to the cloud, and away from datacenters.”
For more attractive yields among companies with plenty of free cash flow (based on his team’s estimates) to cover current dividends and hopefully to raise them, McMahon named General Mills Inc. /zigman2/quotes/206659526/composite GIS +0.81% , with a dividend yield of 3.30%, and Diageo PLC /zigman2/quotes/208129584/composite DEO +1.75% , whose American depositary receipts have a yield of 3.21%.
For some industries, different metrics are used to gauge dividend coverage, so there are three groups of stock screens below. Free cash flow is analyzed for most of the S&P 500. For trailing free cash flow yields, we used free cash flow per share for the past four reported quarters, and divided the sum by closing share prices Oct. 27. For forward free cash flow yields, we used consensus estimates for the next 12 months among analysts polled by FactSet, and divided those totals by the companies’ market capitalization.
For companies in the financial sector, free cash flow estimates aren’t available. We have used earnings per share (EPS) instead, because in this sector EPS typically gives a better indication of actual cash flow than it does for other sectors.
For real estate investment trusts, investors use funds from operations (FFO) to measure dividend-paying ability. FFO adds depreciation and amortization back to earnings, while subtracting gains on the sale of investments. REITs are also required to distribute most of their income to investors, so we will cover this group separately in another article.
Among the S&P 500 /zigman2/quotes/210599714/realtime SPX +1.13% , 381 companies pay dividends and 189 stocks have dividend yields of at least 2.30%. This may not seem to be an attractive cutoff level, but 10-year U.S. Treasury notes /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y -1.15% are yielding only 0.78%. The full S&P 500 has a dividend yield of 1.67%, according to FactSet.
According to S&P Global , 62 of S&P 500 member companies cut or suspended their dividends during the first half of 2020. (Forty-one were suspensions.) That was the fastest pace of dividend cuts since 2009, underlining the importance of having sufficient cash flow to cover dividend payments — and then some.
Starting with the 189 S&P 500 stocks with dividend yields of at least 2.30%, here are the ones estimated to have forward free cash flow headroom of at least 3.00%, based on consensus estimates among analysts polled by FactSet, if available. We have excluded companies that have cut regular dividend payouts at any time over the past five years. This first set of 25 excludes financial-sector companies and REITs, as explained above. The list of financials follow below.
The stocks are sorted by forward headroom.
Scroll the table to see all the data. You can do this by clicking within the table and dragging back and forth.
You can see in the trailing headroom column that a number of these companies haven’t covered their dividends with free cash flow over the past 12 months. The analysts believe they will be able to do so comfortably going forward, but this provides a warning that the pandemic disrupted a company’s business, at least temporarily, or that there was another significant temporary hit to cash flow.
Another factor to consider is that coronavirus infections are rising in the U.S. and Europe, pointing to another year that may include painful shutdowns or low demand for various industries. So there is risk of dividend cuts even if it appears free cash flow will be sufficient to cover planned dividend payouts.
Many stocks on the list have especially high dividend yields, indicating the market as a whole finds the dividends on shaky ground and expects them to be cut. So it is important that before buying any individual stock listed here, you do your own homework to be comfortable the company will be able to sustain its dividend and continue to operate competitively for years. You can start this process by clicking the search icon (a magnifying glass) at the top right of the MarketWatch screen and entering a ticker. Then you will have access to corporate profiles, financials, filings, charts, ratings and estimates.
Among companies in the S&P 500 financial sector, 37 made the list, with estimated earnings yields showing headroom of at least 3.00% over current dividend yields. Once again the list is sorted by forward headroom.
That is a large list, and it reflects the group’s solid capital strength, as well as a stable operating environment since the 2008-2009 credit crisis. So far during the pandemic, banks’ credit quality has held up. It is still early, as federal programs, central-bank stimulus and moratoriums have all worked to delay evictions and missed loan payments. You can read more about the big banks’ third-quarter credit and earnings results here .