By Philip van Doorn
In a world of low interest rates, dividend stocks can be a blessing for investors who need income. But it can be a nightmare if a company cuts the dividend payout.
For example, on May 18, shares of AT&T Inc. /zigman2/quotes/203165245/composite T -1.05% fell 6% after the company announced a change of strategy — a plan to reverse years of expensive acquisitions by spining off WarnerMedia in a deal with Discovery Inc. /zigman2/quotes/200511275/composite DISCA +0.40% . Investors weren’t happy with AT&T’s plan to “resize” its dividend, with the yield on the shares expected to decline to roughly 4% from 7% before the deal was announced.
The spin-off hasn’t been completed yet, and the dividend hasn’t been cut, but AT&T’s shares have fallen 13% (excluding dividends) since May 17, while the S&P 500 Index /zigman2/quotes/210599714/realtime SPX -0.11% has risen 7%.
Marc Lichtenfeld, the chief income strategist for the Oxford Club, an investment-research firm headquartered in Baltimore, rates stocks for dividend safety, taking different approaches for different types of companies. Three examples of higher-yielding companies with “A” ratings for dividend safety are below.
Dividend safety ratings
Lichtenfeld writes the Safety Net column, and his team’s quantitative dividend safety ratings are available to Oxford Income Letter subscribers. The model rates all dividend stocks for which the required input data are available. During an interview, he explained how his dividend safety model works.
Dividend payout ratios
For most companies, Lichtenfeld likes to see a dividend payout ratio of 75% or less — otherwise, the dividend safety rating will be lowered. Dividends on common shares paid during a fiscal year shouldn’t exceed 75% of a company’s free cash flow for the year. Free cash flow is a company’s remaining cash flow after planned capital expenditures. It is money that can be used for dividends, share buybacks, expansion or for other corporate purposes. A very high payout ratio may be an indicator that a dividend cut is coming, unless it is a temporary condition.
If the data are available, the dividend safety model will incorporate payout ratios based on consensus estimates for the current fiscal year, as well as historical numbers.
For most real estate investment trusts (REITs), which are required to distribute most income, the acceptable payout ratio is 100% of funds from operations (FFO), which is commonly used in the REIT industry to gauge dividend-paying ability. FFO adds amortization and depreciation back to earnings, while excluding gains on the sale of investments.
For mortgage REITs, which originate loans and/or focus on investing in mortgage-backed securities, Lichtenfeld will use net interest income as a proxy for FFO.
For energy master limited partnerships (MLPs), payout ratios can also go up to 100% without penalties to the dividend safety rating. For MLPs, Lichtenfeld’s model will compare dividend payouts (technically, distributions to partnership unit holders) to reported distributable cash flow or investment income, “whatever the company reports as a proxy for free cash flow,” he said.
For banks, the ratings model looks back to calculate payout ratios based on net interest income.
Other factors — growth, leverage and dividend cuts
Lichtenfeld’s dividend safety ratings incorporate free cash flow growth, or the other factors mentioned above for REITs, MLPs and banks, as well as the growth of dividends. Companies that raise dividends for 10 consecutive years will have a “bonus” added to the scoring for dividend safety ratings. The pace of dividend growth can also improve the ratings.
A company that has cut its dividend within the past 10 years will have a penalty to its rating. For example, Kinder Morgan Inc. /zigman2/quotes/208455654/composite KMI +0.80% is rated a “C,” even though its payout had more than doubled in 2020 from 2017, in part because the pipeline operator cut its dividend by 75% late in 2015, but also because of a high level of debt .
Lichtenfeld explained that since the model looks at full fiscal years, corporate announcements can cause adjustments to be made to the safety ratings between annual reporting cycles. AT&T hasn’t cut its dividend yet, but since a plan to reduce the payout has been announced by the company, its dividend safety rating is “F.”
Three companies with ‘A’ ratings
Lichtendeld discussed three “higher-yielding” companies rated “A” for dividend safety:
Omega Healthcare Investors Inc. /zigman2/quotes/208032080/composite OHI -1.16% is a REIT with a dividend yield of 8.51%. It invests in health-care properties in the U.S. and U.K. The company’s FFO per share for 2020 was $3.20, while dividends per share for the year totaled $2.68, according to data provided by FactSet. For 2021, the consensus FFO estimate among analysts polled by FactSet is $3.30, while the current annual dividend payout rate remains $2.68, so the dividend appears to be well-covered. The dividend hasn’t been increased since November 2019, but the company’s annual dividends paid have increased 18 years in a row through 2020.
Arbor Realty Trust Inc. /zigman2/quotes/208546438/composite ABR +0.15% has increased its dividend for nine consecutive years. The stock’s current yield is 7.63% with an annual dividend payout rate of $1.40 a share. Arbor Realty is a mortgage REIT — it is a residential mortgage lender and loan servicer. It sells some of its newly originated loans to Fannie Mae /zigman2/quotes/208846331/delayed FNMA -3.38% and Freddie Mac /zigman2/quotes/202741363/delayed FMCC -2.35% . Because of the nature of Arbor’s business, Lichtenfeld uses net interest income (the spread between income from loans and securities investments and the cost of funding) to measure this REIT’s dividend-paying ability. During 2020, Arbor’s net interest income totaled $170 million, while distributions paid on common stock totaled $142 million. That was a payout ratio of 84%. The company has increased its dividend for nine straight years. Lichtenfeld said he was impressed with the pace of dividend increases. The payout increased 8% in 2020, following double-digit increases during the previous three years, according to FactSet.
Investors Bancorp Inc. /zigman2/quotes/210297037/composite ISBC +1.52% of Short Hills, N.J., has a dividend yield of 3.85%. During 2020, the company’s net interest income totaled $726 million, while dividends paid on common shares totaled $113 million, making for a payout ratio of only 16%. The company has raised its payout seven years in a row, with a 9% increase in 2020, following double-digit increases the previous four years.