By Brian Nelson, CFA

To no surprise to many members, several dividend growth strategies have faced tremendous pressure during 2020. The Journal recently wrote a piece on the topic, but from our perspective, the problem with many dividend growth strategies is that they tend to be balance-sheet agnostic and pay little attention to traditional free cash flow expectations, focusing only on the yield itself, sometimes dismissing future fundamentals in favor of historical growth trends and the inferior EPS-based dividend payout ratio.

In many dividend-targeted ETFs, for example, it may not matter to the index creator whether a firm has $10 billion in net debt or $10 billion in net cash; as long as management has a track record of raising the dividend in the past, it is included. To us, however, there is a world of difference between a company that has a huge net cash position and a huge net debt position. The more excess cash on the balance sheet a dividend payer has, for example, the more secure its payout.

In some cases, entities held in high-yielding ETFs don't even cover their dividends or distributions with traditional free cash flow generation, despite having ominous net debt loads. A look at the high-yielding ALPS Alerian MLP ETF (AMLP), for example, shows a number of entities that are buried under a mountain of debt and are generating meager free cash flow relative to expected distributions. The lofty yield on that ETF should therefore be viewed with a very cautious eye. If the yield weren't at risk for a big cut, the market would bid up the stock, and down the yield would go.

In no way should you believe that you can sleep well at night holding stocks yielding north of 10% when the current 10-year Treasury is well below 1%. The market is just not that inefficient. A dividend growth strategy can never be a passive one either. Only through constant attention to the balance sheet (net cash) and future free cash flow expectations can investors truly sleep well at night. At Valuentum, we do the balance sheet and cash flow work and summarize it succinctly in a key ratio called the Dividend Cushion ratio.

For new members, the Dividend Cushion ratio can be found in the Dividend Report and is derived from the forecasts within our discounted cash-flow models. When a Dividend Report has been published for a company in our coverage, the Dividend Cushion ratio is included in the table on their respective stock page (here is Apple's, for example). You can read more about the efficacy of the Dividend Cushion ratio in warning about future dividend cuts here, a track record that has been phenomenal.

Without a doubt, the stories of the massive fall out and dividend cuts of General Electric (GE), Kinder Morgan (KMI) and many others speak to the importance of assessing the net balance sheet position and expected traditional free cash flow generation of a stock. Just like with the best ideas in the Best Ideas Newsletter portfolio, we want dividend growth entities to have massive net cash positions and generate free cash flows well in excess of expected dividends paid. But how many investors, for example, were completely swept away by Energy Transfer's (ET) near-20% dividend yield prior to the pipeline operator slashing the payout and are still enamored by Exxon Mobil's (XOM) current 10%+ dividend yield?

My guess that there are too many. Prior to Energy Transfer's dividend cut, for example, the pipeline company registered a very weak Dividend Cushion ratio of 0.2; anything below 1 is considered risky, while anything below 0 is very hazardous with respect to expectations of its sustainability. There have been dozens upon dozens of MLP distribution cuts the past few years. Today, even energy major Exxon Mobil sports a Dividend Cushion ratio near 0, so we wouldn't be surprised if the entity were to cut its payout in the near term.

Many business models, including MLPs but also REITs (VNQ) aren't able to build up significant net cash reserves that we like in strong dividend payers. To very little surprise to us, some 60+ equity REITs and 30+ mortgage REITs cut their dividends during the second quarter of 2020, according to Hoya Capital Real Estate. How many articles have you read on the REIT space on Seeking Alpha or elsewhere about how "safe" the dividend yields of REITs were though? Far too many. On the other hand, here's what Valuentum wrote in every REIT Dividend Report that we published:

REITs pay out 90% of annual taxable income and therefore are unable to meaningfully reinvest internally-generated funds, resulting in external capital-market dependence. The weak internal cash-flow retention of most REITs translates into poor raw, unadjusted Dividend Cushion ratios, which could become severe during the depths of the real estate cycle. Even though a REIT's operating cash flow may be robust, the lack of cash accumulation on the balance sheet and the massive debt needed to purchase/develop new properties can become restrictive. The adjusted Dividend Cushion ratio accounts for expectations of continued access to the capital markets, which while "normal," cannot be guaranteed in times of tight credit.

At the core, the unique and proprietary Dividend Cushion ratio measures the financial capacity of a company to pay and grow its dividend. It sums up the existing net cash (total cash less total debt) a company has on hand (on its balance sheet) plus its expected future free cash flows (cash from operations less all capital expenditures) over the next five years and divides that sum by future expected cash dividends (including expected growth in them, where applicable) over the same time period. As a forward-looking free-cash-flow dividend coverage metric that considers the balance sheet, the Dividend Cushion ratio is one of a kind.

An elevated ratio doesn't ensure the company will keep paying dividends, however, as management's willingness to do so is another key consideration, but the ratio acts as a logical, cash-flow based ranking of dividend health, much like a corporate credit rating, for example, ranks a company's ability to pay back debt (default risk). We view the Dividend Cushion ratio as an indispensable and unmatched feature of our service and use the ratio as a key consideration with respect to companies in the Dividend Growth Newsletter portfolio. Many of the companies in the Dividend Growth Newsletter portfolio, for example, have a strong combination of a solid dividend yield and solid Dividend Cushion ratio.

An actively managed, prudent and responsible dividend growth strategy set to achieve long-term goals has tremendous merit. At the new registered investment adviser, we plan to serve investors and advisors that are looking for a money manager to pursue a dividend growth process, and we plan to continue publishing some of the best dividend-related analysis on the web through Valuentum! By the way, have you checked the Dividend Cushion ratio on your companies lately? Make sure you do so before it's too late. Use the symbol search box to access a company's stock page, and then view the data table or download a company's Dividend Report.