Over the past two years, we have seen a record number of dividend cuts in the history of dividend growth investing. As most media are quick to jump the gun and blame the COVID-19, the situation is far from being so simple. In fact, many companies would have cut their dividend sooner or later anyway. The pandemic acted as an accelerator for both camps: it crushed weak companies and propelled thriving ones.

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Between 2010 and early 2020, the market became complacent. The economy was growing steadily, interest rates remained low and the appetite for new debt was high. Many mediocre businesses jumped into investors’ fishnets and entered the boat. Many income-seeking investors were happy to gather 6%+ yielding stocks.

2021 is completely different than 2020, but the same overriding theme remains: one must be cautious and adapt his/her portfolio to protect it from dividend cuts. One year it’s a pandemic, and the next year it’s inflation. There seems to always be something lurking in the dark that could jump on your dear holdings and force the weakest link to break. I’d like to offer you my three favorite techniques to avoid those cuts. They have been proven to be highly effective in the past. Besides a few exceptions due to the nature of the exceptional economic lockdown we suffered, we were able to avoid most of the dividend cuts at DSR.

The following is a short and applicable list of actions you should take with your portfolio this summer. There is nothing like hanging around a pool and optimizing your portfolio. The volume will be lower, volatility will take a pause, and it will be time for you to take a deep breath and make sure you don’t suffer from additional cuts this fall.

#1 Trust the market – beware of high dividend yield stocks

My first indication that something may be wrong is usually the market action itself. While I don’t rely on it, there is still some truth-speaking from the action in the market. When a sector or most of the market follows the same movement, it’s difficult to understand exactly what the market is telling us. However, when you see companies that are getting beaten down more than others, this is normally a sign that something is wrong.

Keep in mind that we are operating in a world of low-interest rates where there is plenty of liquidity around. As the stock market surged following the influx of stimuli there is no reason now to offer a 5-6%+ yield with no risk. When the food is on the table and nobody takes it, maybe you should ask who’s the chef. Don’t fall for the yield trap because this is what it is very likely to be.

If you have been reading my work for a while, you already know I’m not keen on high-yielding stocks. High dividend-yielding stocks (5%+) often offer either a higher degree of risk, poor growth perspectives or most likely both. Since I’m not looking for an immediate source of income, I don’t have to bother with high-yielding stocks. However, whenever I hold a stock where the yield goes over 5% like Enbridge (ENB), I will pay more attention.

Not all high-yield stocks are bad investments. You will find some interesting picks in this category. A quick search using the DSR stock screener could help you build a list of decent high-yield stocks. By selecting a minimum PRO rating and Dividend Safety Score of 3 (we want a stable company able to match or exceed the rate of inflation with its dividend growth rate) along with a minimum yield of 5%, you can find a list of about 30 stocks.

Here are a few examples.

This is not an exhaustive list, but rather just a few examples of great companies offering a higher yield than the norm. Last year, you even had the opportunity to catch Canadian banks offering 5-6%.

The point here is not to completely avoid stocks with a yield greater than 5%, but rather not to concentrate your money into that type of higher risk holding. Remember that there is no free lunch in finance and investments. There are reasons why those companies are “so generous” with their dividends. One must follow those companies closely and make sure to review each quarterly report with close attention.

#2 Avoid stocks with an absence of dividend growth

As the inflation rate hasn’t been excessive over the past 10 years, most income-seeking investors don’t factor inflation into their investment decisions. Many tell me, “Mike, I’m retired, and I need this 8% income, I don’t care about inflation”. I can understand that position if you have $1M invested at 8% and you only need $60k/year to live. This means inflation can eat up $20,000 per year in dividend income before it affects your lifestyle. That may make sense to some folk.

However, now that inflation is ramping up, this threat may become a little bit more serious. I’m not here to be the fearmonger and tell you that we will go straight into a hyperinflation phase. Most of the inflation we have seen in the past month is simply the return to “normal” after having such a low inflation rate and injecting so much money into the economy in a short period. We must wait several months to see if the inflation rate continues to rise or if it was just an adaptation period as the Fed thinks.

Now, back to the “no dividend growth stocks”. The problem is that many companies that keep their dividends static will eventually cut it. If management can’t increase its payout when the economy is growing, what will happen during a crisis? You are correct – they may be among the first to cut their dividend. I tried to find companies where they were showing growing revenues and earnings but with no dividend increases over the past 5 years. They are rare. In fact, most “non-increasing” dividend-paying stocks will eventually look like this:

Source: Ycharts

Before telling me H&R REIT (HRUFF) cut their dividend because of the COVID-19, please keep in mind that the company also had to cut it back in 2009 as well. In fact, this is pretty much a copy/paste scenario of the last crisis. In the early 2000s, the REIT grew for about 10 years and then cut its dividend by 50% to preserve the business. 10 years later, we see the same scenario evolving.

This tells you a lot about their business model. H&R is a classic “I look good on Prom Night” company. When the economy is doing well, and the market is rising it’s like a wave. All the “trash” comes on top and it’s nearly impossible to differentiate what looks like a fish or a bottle from the shore. Once you get closer and analyze the ocean, you realize the wave will bring a lot of trash once it crashes.

If you go back to your portfolio now and look for companies that have not consistently increased their payouts between 2015 and early 2020, chances are they have reduced their dividends, or they haven’t fully recovered from the March 2020 market crash. It’s time to act now and look at which holdings would do a better job with what is left of your capital. Don’t wait for the full recovery as it may be a painful path that will only lead to more losses. Both the Canadian and the U.S. markets have more than recovered already. Companies that have not recovered have been left behind as their flaws have been exposed.

#3 Weak dividend triangle

You know that by now the dividend triangle is a very strong indicator when it comes to assessing the likelihood of a dividend cut. The Dividend Triangle is composed of three metrics:

Revenues: A business is not a business without revenues. What is the difference between a company making growing revenues versus a company showing stagnating results? We are looking for companies with several growth vectors that will ensure consistent sales increases year after year. I’m a big believer in “offense is the best defense”. Whenever we are about to face a recession, I want to make sure I have companies that have shown past revenue growth. This is an excellent indicator that their business model is doing well, and they don’t enter a recession in a position of weakness.

Earnings: You cannot pay dividends if you don’t earn profits. If earnings don’t grow consistently there is no point of assuming that the dividend payment will increase indefinitely. Keep in mind that the EPS is based on a GAAP calculation. This is what makes EPS imperfect, as accounting principles are not aligned directly with cash flow. This means you are better off looking at the EPS trend over 3, 5, and 10 years. Use an adjusted EPS that takes off those one-time events revealed by the company to have a clear view of what is happening. Some companies “play around” with earnings for a year or two, but you can’t create a trend out of thin air.

Dividends: Finally, dividend payments are the *obvious* backbone of any dividend growth investing strategy. But I don’t focus on the real dollar amounts or the yield.  I focus solely on dividend growth. Dividend growers show confidence in their business model. This is a statement claiming that the company has enough money to both grow its business and reward shareholders at the same time. This also tells you that the business can pay off its financial obligations and invest in new projects (CAPEX). No management team will increase their dividend if they lack the cash to run their business.

Companies losing market share due to the lack of competitive advantages will see their story through their revenue trends. It is very rare to see a business reporting growing revenues year after year. For many reasons, a company could publish weaker results. It could be the end of a cycle, a change in the business model, or simply the economy slowing down. However, if this situation persists for several years and management can’t find growth vectors, the red flag must be thrown.

The same logic applies to earnings. Since earnings calculations are based on GAAP, we are not talking exclusively about real money. This number is far from being perfect. In fact, you are better off combining it with free cash flow or cash flow from operations to see what is really happening inside a company. Nonetheless, if a company is unable to generate growing EPS over a long period of time (5 to 10 years), chances are dividend growth will not happen either.

Finally, as I discussed earlier in this article, a lack of dividend growth is a sign there is a problem that must be investigated. When management is confident enough to raise their payouts by 4-5% or more each year, I can sleep well at night, and I really don’t mind what is happening in the market. Sooner or later, the market will bounce back, and dividend growers are among the companies that will thrive.