How to Avoid Dividend Disasters

The Biggest Dividend Disasters

• Dividend stops being paid• Dividend eats up capital• Incredible shrinking dividend• Company runs out of cash• Bankruptcy• Business model stops working

Causes of Dividend Disasters

• Dividends not covered by income or cash flow• Business depends on finite assets or leases• Business model produces declining income– Fixed line telecoms– Old mines or oil/gas properties– Buildings reaching end of business life

• Business model depends on market distortion– Mortgage REITs

Avoid Disasters with the Certainty Index

• Fundamental question: Will the dividend continue to be paid?

• Index covers both short and long term• Short-term: Are the next couple of quarterly

dividends safe?• Long-term: Will the dividend continue or

increase over the next three to five years?• Modified, can also be used for options and

takeovers.

The Short-term Certainty Index

• Ratio of Earnings to Dividends Paid (35%)• Ratio of Cash Reserves to Dividends Paid (20%)• Historic Variability of Quarterly Earnings (20%)• Risk of Upsets to Business Model (15%)• Past Persistence of Dividends (10%)

Grade each out of 10 and take the weighted average; the result is roughly the probability of payment.

Example: Safe Bulkers Inc. (NYSE:SB)

• Earnings $1.19, dividends $0.60 – 9• Cash reserves $28.1m, dividend $11m – 8• Last four quarters: $22m, $21m, $24m, $20m – 9• Risk of upsets to business model – 4 – Bulk carrier rates very volatile, not all on time charters

• Past persistence -- $0.15/quarter since 2009 – 7

Conclusion: SB has Short-term Certainty Index Rating of 8.05 out of 10 (high safety).

The Long-Term Certainty Index

• Risk of upsets to business model – 30% • Past persistence of dividends – 25% • Variability of annual earnings – 20% • Dividend times coverage – 15%• Ratio of Cash Reserves to Dividends Paid – 10%

Grade each out of 10 and take the weighted average; the result is roughly the probability of payment.

Example: Safe Bulkers Inc. (NYSE:SB)

• Risk of upsets to business model – 3– Bulk carrier market very subject to overbuilding

• Past persistence -- $0.15/quarter since 2009 – 6• Last five years of earnings: $90m, $110m, $165m, $119m, $209m

– 5• About two times covered – 9• Cash reserves $28.1m, dividend $11m – 8

Conclusion: SB has a Long-term Certainty Index Rating of 5.55 out of 10 (marginal safety).

Overall: SB solid in the short term, needs watching long term

Example: American Capital Agency Corp. (NasdaqGS:AGNC)

• Mortgage REIT• Buys mortgage bonds, finances in repo market• Highly vulnerable to interest rate rise

Certainty Index analysis:• $3.58 earnings, $5 dividend – 2• Cash reserves $2401m, dividend $286m – 9• Last four quarters: $264m, $641m, $209m, $251m – 2• Risk of upsets to business model – 2• Persistence – was $1.40, now $1.25 – 4• Score: 3.6 • Long-term score 2.9 (dangerous)

Example: Frontier Communications Corp. (NasdaqGS:FTR)

• Rural telecom co. recently merged Verizon• Landline business eroded, div declining

Certainty Index analysis:• Earnings roughly 25% dividends – 1• Cash reserves $421m, dividend $96m – 7• Last four quarters: $27m, $42m, $20m, $32m – 4• Dividend now $0.10, was $0.25 – 1• Risk of upsets to business model – 4• Score: 3.1 • Long-term score: 3.1 (dangerous)

Conclusion

• Dividend disasters kill portfolios– Income AND Capital loss

• Certainty Index helps avoid them - screens good from bad

- Short-term and long-term analysis

Good Investing!