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3 signs of a safe dividend

Josh Peters  |  14 Jan 2016Text size  Decrease  Increase  |  

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Josh Peters is Morningstar's US-based director of equity-income strategy. This article initially appeared on the Morningstar US website.

 

Dependable. Stable. Reliable. These words often come to mind when investors think of dividend-paying stocks. But how can you make sure the stock you own today will continue to pay its dividend tomorrow?

Morningstar's US-based director of equity-income strategy, Josh Peters, argues that a trio of factors collaborate to generate a steady stream of dividends. Here are the signs to look for when evaluating a company's ability to maintain its dividend.

1) An economic moat

An economic moat, which encapsulates a company's competitive advantage, is one of the best tools to identify the stability of a company's profit stream. As such, it's one of the most important metrics for dividend-stock investors to evaluate.

"If you're hanging around for the dividend over the long run, then you have to think about the company's long-run earnings power, and that is almost entirely going to be shaped by the company's competitive position in its industry," says Peters.

"No-moat companies are substantially more likely to cut their dividends during recessions than narrow- and wide-moat firms," says Peters. That's because these companies' profits--and, therefore, their dividends--are more vulnerable than those of wide-moat firms.

"An economic moat does not guarantee dividend safety, of course," adds Peters. General Electric (GE) held a wide moat rating when it reduced its dividend in 2009, he says. Nevertheless, moats offer some protection of future dividend payments. As such, Peters requires that a company earns a Morningstar Economic Moat Rating of narrow or wide before investing.

2) Strong finances

Common-stock shareholders collecting dividends sit on the bottom rung of a company's ladder of financial obligations. They're only paid after other obligations--such as those from banks, bondholders, suppliers, employees, pensions, and so on--are met.

"Being the last in the pay line, we want to see that this line is not too long," says Peters.

Peters warns that with highly leveraged companies, it's especially important to be aware of financial covenants with bankers or bondholders that can trigger defaults even before the company runs out of resources.

"If this seems beyond your grasp, simply avoid highly leveraged situations," he advises.

Peters also recommends that dividend investors understand all claims on a company's cash, which may include pension deficits, tax problems or legal threats.