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The Dividend Dilemma: A Warning for Investors

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Investors have always had an affinity for dividends. They eagerly await the moment when their dividends are paid out and rejoice when they see an increase in their payouts. Conversely, the prospect of dividend cuts fills them with dread.

Unfortunately, it is an unavoidable truth that some major companies will be forced to reduce their dividends in 2024. Consulting firm McKinsey’s research reveals that, outside of financial crises, approximately 1% to 2% of all dividend payers decrease their payouts each year. This translates to around seven or eight significant companies. The key for investors is to identify these companies and exercise caution until the dividends are indeed slashed. This is when a unique opportunity arises.

Detecting which companies are on the verge of cutting their dividends is no easy feat. However, according to Wolfe Research strategist Chris Senyek, there are three warning signs that investors should pay attention to. Firstly, although high yields may appear enticing, they often indicate underlying issues within a company. Secondly, excessive debt can result in a greater proportion of cash being allocated towards interest expenses rather than being returned to shareholders. Lastly, an excessive payout of free cash flow can leave a company vulnerable during a downturn, especially if a recession is looming.

At present, Senyek expresses concern specifically about consumer-discretionary companies. He has valid reasons for his apprehension. The National Retail Federation expects 2024 to be a challenging year for shoppers, following a successful 2023. The organization’s economist, Jack Kleinhenz, warns that tighter credit conditions and higher borrowing costs continue to impact consumers. Additionally, employment reports affirm that the labor market expansion is gradually slowing down.

Senyek has identified eight companies with his trifecta of concerning metrics – indicators that suggest these companies are at risk of cutting their dividends this year. Vail Resorts, a ski industry giant; Hasbro, a prominent toy maker; Whirlpool, an appliance manufacturer; Wendy’s and Cracker Barrel Old Country Store, both restaurant operators; Leggett & Platt, a home-goods manufacturer; LCI Industries, an RV parts supplier; and Kohl’s, a well-known retailer, are all on his radar.

In conclusion, investors must be vigilant and exercise caution amid the possibility of dividend cuts. Identifying the warning signs and staying away from compromised companies will ultimately prove beneficial. Remember, it’s all about recognizing the opportunity when the dividend payout is slashed.

Dividend Payouts and Debt Levels of Companies in the S&P 500

It is projected that certain companies in the S&P 500 index will pay out approximately 100% of their estimated 2024 free cash flow as dividends. This is significantly higher than the average dividend payer in the index, which has a payout ratio of 55%. While companies can temporarily pay more cash than they generate, this leaves essentially no buffer.

Another concern is the large debt loads carried by these companies. On average, the dividend payers in the S&P 500 have 2.2 times more debt than Ebitda (earnings before interest, taxes, depreciation, and amortization), which is considered manageable. However, the eight stocks highlighted by Senyek have an average leverage ratio of 4.2 times. Additionally, these stocks have an average dividend yield of 6%, which is more than double the 2.5% average yield of dividend payers in the S&P 500.

While a dividend cut may initially cause a decline in stock value, it can also present an opportunity for investors. For example, Intel experienced a 40% decline in the year leading up to its dividend cut in February 2023. However, since then, its shares have increased by approximately 80%. Overall, Senyek’s analysis reveals that stocks of companies that have cut dividends underperform the market by around 17 percentage points in the year preceding the cut. However, their performance starts to improve about three months after the cut, with these stocks outperforming the market by approximately five percentage points one year later.

When facing potential dividend cuts, it is crucial to exercise patience and carefully evaluate investment opportunities.

Sources: Bloomberg, FactSet, Wolfe Research

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