By Brian Nelson, CFA
I think a lot of investors sell themselves short.
Of course you want a strong and growing dividend, but analysis shouldn’t stop there. One of the most important things you could ever do is evaluate just how strong that dividend truly is via the Dividend Cushion ratio, a metric that measures a company’s dividend coverage via future free cash flow generation with consideration of its balance sheet health. For example, how valuable would it have been to know that Kinder Morgan (KMI), ConocoPhillips (COP), and BHP Billiton (BHP) were going to cut their dividends…in advance of them doing so? Our membership knew these cuts were probable long before anyone else because they paid attention to each firm’s Dividend Cushion ratio. The Dividend Cushion ratio provides this valuable information in a systematic, objective, and forward-looking fashion. We believe having access to this ratio is par for the course for any dividend growth or income-oriented strategy. It has to be – you’re interested in dividend growth and safety, and that’s exactly what the Dividend Cushion measures with the evaluation of the financials. Backward-looking data should be free – it’s the forward-looking analysis that’s worth paying for.
A dividend growth or equity income-oriented strategy may start with a fantastic payout, but it doesn’t have to stop at the evaluation of the dividend. Certainly many dividend growth investors don’t care much about the price of the equity, for better or worse, even as we continue to warn about the hazards in ignoring this very important information, but what happens when shares of a company keep falling, and then the company cuts its dividend? Dividend growth and equity income-oriented investors are left with permanently-eroded capital and then a reduced income stream? It’s a double-whammy. We saw this with all of the three high-profile situations mentioned above—Kinder Morgan, ConocoPhillips, BHP Billiton–and also with Teekay LNG Partners (TGP) as of late, where the latter’s shares cratered before the company cut its dividend…and then after as well. All of these were avoidable. Please stay on top of each of your holdings’ Dividend Cushion ratio; in the cases of Kinder Morgan, ConocoPhillips, BHP Billiton, and Teekay LNG Partners, among many others, it highlighted the significant risk of a dividend cut far in advance.
Who is teaching people to completely ignore valuation and market information and focus only on a dividend or distribution that may be financially-engineered, as in the case of most MLPs (AMLP)? Please — the market price holds very, very important information – all four of the examples above, shares were collapsing before they cut the dividend. Please –- do not let anyone tell you that market information does not matter. Share price action will always offer some clues! Do you really think that the backward-looking GAAP financials tell the whole story about a company? Any time investors take their eye off of valuation or fundamentals, as in the dot-com bubble or other bubbles before it, they always get hurt. Please don’t just stop at the dividend — keep doing your homework. Whether it is staying on top of the Dividend Cushion ratio or our extensive discounted cash flow processes, or more.
Trust me — it will help you over the long haul.
By the way, it turns out that Berkshire Hathaway, the company that Warren Buffett oversees, and not Warren Buffett bought Kinder Morgan, or at least that’s the latest word. If this matters to you, you are focusing on the wrong news and information. Shares of Kinder Morgan are rallying more than 3% today, and the company continues to be a part of the Best Ideas Newsletter portfolio. Missed our valuation-driven change of opinion on KMI — read our work that Barron’s highlighted here (Jan 21).