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You hear phrases
like these often in the investment world. Commercials for TD
Ameritrade and Charles Schwab continuously pound nonsensical
comparisons into viewers' heads. In the end, these are
important concepts. But are they really important to the
average investor? After all, don't people invest to make
money -- not compete with others?
It's important to step back and look at what you're
doing. In fact, we'd argue that it's the most important part
of investing. If you are looking to average a 3% gain,
that's fine. But it's important to realize it. Above all,
however, we expect companies we invest in to pay us our
share.
Dividend investing was once the easiest way to invest.
All it took was a quick screen of companies that had paid
steady dividends over decades. Today, we don't have the same
luxury.
In 2008, the S&P 500 saw 62 dividend cuts. That
translates into $37 billion down the tube. With the likes of
GM and Bank of America slashing their payments, nothing
seems easy anymore. We have to be very careful these days.
That's why payout ratios are so important.
Payout ratios are simply the percentage of company
profits investors receive in dividends. Most young businesses have low
payout ratios. That's because they need to put more money
into their businesses for future growth. Likewise, older,
more established organizations distribute more of their
income to shareholders.
Older companies with low payout ratios are basically
stealing from you. Younger companies with high payouts are
stunting their growth. Unfortunately, no investment is as
simple as that...
You see, too high a payout ratio could also mean the
company will have to cut its payments in the future. On the
other side of the coin, too low a payout could mean the
company won't ever pay shareholders their... well, share.
A perfect balance is hard to find, especially in this
market.
Take Pfizer, for instance...
The drug giant has paid shareholders a growing dividend
for 42 straight years. Meaning Pfizer increased its
dividend-per-share amount every first quarter of the year
for over four decades. In the middle of December, that all
changed.
The company decided to stick with its current quarterly
dividend of 32 cents per share. A news story like this
barely receives any airtime on shows like Mad Money and
Squawk Box. That doesn't mean, however, it isn't an
important development.
Pfizer's payout ratio reached a peak of 78% at the end
of 2007. That's quite a buildup from just 40% in 2004. With
economic turmoil and a dwindling drug pipeline, Pfizer
decided it's better to level its dividend out for a while
and reinvest it back into the company (i.e., the acquisition
of Wyeth).
Of course, this story changed again the last week of
January. Pfizer cut its dividend in half to 16 cents a
share. This cut did make some news channels, but only after
it was too late.
Income investors have to be on their toes. For the
Pfizer shareholders who didn't catch it in December, the
January announcement came as quite a blow. Since then,
shares are down nearly $3 per share -- most of that coming in
the first hour of trading after the cut was announced.
Unfortunately, we are seeing this more and more since
the credit market completely froze up last year. That's why
smart income investors are keeping a closer eye than ever on
payout ratios.
Here are some hard and fast rules to follow when it
comes to payout ratios:
 If a company pays out more than 60% or 70% of its
earnings to shareholders, be wary. This could mean the
business isn't growing fast enough to cover its growing
dividend
If
a company pays less than 20%, it is ripping you off. Only in
cash-intensive businesses like heavy manufacturing is this
acceptable. But wouldn't you rather own a cash cow, like a
pipeline trust?
If a payout ratio spikes, check to see if it is a
one-time expense artificially pushing the ratio out of
whack. Most of the time, a payout will spike because of an
acquisition or a nonrecurring payout. If not, panic. That
means a company isn't making what it used to.
Some companies' payout ratios are more volatile than
others. The more volatility, the better chance of a dividend
cut (or increase).
Of course, there are exceptions to these rules. Master
Limited Partnerships, for example, are required by law to
pay out at least 90% of their earnings to investors. Income
streams for those companies are so steady that such a high
payout is completely acceptable.
Other such examples pop up every once in a while, and
it's important to stay ahead of the curve.
Jim Nelson
Managing Editor
Penny Sleuth
P.S. Whether we are
talking about payouts, dividend hikes, dividend cuts, new
opportunities, or anything else in the income world, readers
of my Lifetime Income Report do stay ahead of the curve. In
fact, I just put together a brand-new report featuring a
strategy I call "Retirement: Plan B". I urge you to
check it out here...
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