Nearly every retirement portfolio on the planet is reeling from the coronavirus fallout. Recoveries are going to vary widely, however, depending on the safety of the dividends in each basket.
If your income stream is safe, then you’re well ahead of the game. When stock prices recover (and they will, as every bear market eventually gives way to a new bull), your portfolio is going to bounce right back. Assuming the payouts didn’t miss a beat, then you can rest assured you’ve got an uninterrupted income stream between now and then.
The bad news, however, is that cuts to dividend payouts have already started, with Ford (F) suspending its payout last Thursday. Then there’s Boeing (BA), which was a basket case before the coronavirus outbreak. The company’s dividend yield surged to 8.4% … right before the company suspended it on Saturday.
Those are just two obvious tickers to dump now, if you haven’t already. We’ll name four more shortly.
First, though, let’s talk about that one-step “dividend safety check” you can perform on your stocks right now.
Performing this simple test will help secure your income stream and, if it leads you to sell any laggards, free up cash for the fantastic buying opportunities we’ll see in the weeks and months ahead.
Your “1-Click” Dividend Safety Check
I’m talking about checking the payout ratio on each of your holdings. If you’ve been buying dividend stocks for a while, you likely know the payout ratio. You calculate it by dividing the total amount of dividends paid by the company’s last 12 months of net income.
Generally speaking, if you’ve got a stock with a payout ratio of 50% or less, its dividend is likely safe. As you climb closer to 100%, the payout’s safety falters.
But there’s a problem with this formula, and it’s on the “net income” side of the ledger. Put simply, net income is an accounting creation. It can be easily manipulated to overstate cash-flow generation. But it can, at times, understate it, too.
Take insurer Chubb Inc. (CB), for example. It recently popped up on a Barron’s list of high-quality, defensible dividends due to its low net income–based payout ratio: a mere 30.4%.
However, this is one case where net income is understating cash flow: the insurer’s free cash flow payout ratio is even better: just 21.4%. And that ratio has actually been moving lower in the last three years!
In other words, Chubb could double its payout tomorrow and still stay well below our 50% “safety line.”
But let’s back up a second: what do we mean by “free cash flow payout ratio”?
Free cash flow (FCF) tells you how much cash a company is generating once it’s paid the cost of maintaining and growing its business. You calculate it by subtracting capital expenditures from a company’s cash flow from operating activities (both figures are available under the “Financials” tab on Yahoo Finance). It’s a much more accurate view of the cash a company is generating than net income.
We’re going to get into four stocks with dangerous free-cash-flow payout ratios in just a few moments more. First, though, let’s square the circle on Chubb.
Coronavirus No Match for Chubb’s Dividend
If you’re looking for a safe-dividend checklist (and who isn’t these days?), Chubb provides us with a few other strong points to look for.
Aside from its safe FCF payout ratio, the company also boasts rock-solid dividend history: Chubb is a member of the Dividend Aristocrats, the 57 US companies that have raised payouts for 25 years or more (including many previous crashes, such as the financial crisis, the dot-com bust and 9/11).
And on February 27, well after the market had already started falling from its February 19 peak, Chubb rolled out another hike, to the tune of 4%. That’s a pretty strong statement from management.
Finally, the payout is backed by Chubb’s strong balance sheet, with $15 billion of long-term debt, as of December 31—just 8% of its $177 billion in assets—and $5.8 billion of cash on hand.
Now let’s wrap up with a look at those four dangerous dividends I mentioned earlier, as measured by their FCF payout ratios.
4 Dangerous Dividends to Dump Now
Western Digital (WDC) has taken a double hit from the coronavirus, with demand for its memory chips falling in China first, and now, with the outbreak in Europe and North America, in those markets, too. Meantime, WDC’s cash holding is shrinking as its dividend—unsustainable through cash flow—is paid out of pocket.
Next, it’s no surprise that Wyndham Hotels & Resorts (WH) is taking a hit from the coronavirus, prompting the company to withdraw its outlook for 2020. Given that it was already paying 224% of cash flow as dividends as of the end of December, we can assume this payout is on borrowed time.
Abercrombie & Fitch (ANF), meanwhile, shuttered all its stores outside the Asia-Pacific region on March 15. It will continue to sell online, but faces a lot of competition in that space, as well. The dividend, which consumes 154% of FCF, seems likely to be cut to save cash.
Finally, ExxonMobil (XOM), whose dividend was already in jeopardy before the double hit of the coronavirus and the oil-price war hit. Don’t gamble on this 10% yield. It’s a trap ready to spring.
Brett Owens is chief investment strategist for Contrarian Outlook. For more great income ideas, click here for his latest report How To Live Off $500,000 Forever: 9 Diversified Plays For 7%+ Income.