Are the Experts Right?
Sometimes those who look like experts can make appalling decisions and poor recommendations. This includes experts that I follow to see what advice they are giving. There are certainly many times when their views are valid, and their recommendations are worthy of consideration.
However, if you haven’t learned it by now, you need to read or listen to every recommendation with a hint of skepticism. When it comes to investing, you should have a goal statement that helps you pick investments that fit your goal. As a dividend growth investor, I have five main requirements I always review before I enter a buy limit order for a stock or an ETF. Those rules sometimes tell me the expert is likely wrong.
I have been watching the stock of Royal Dutch Shell (two tickers: RDS.A & RDS.B) because I was seeing reports that the company was a good investment. In fact, in the following email image I received this morning, you can see the headlines for three expert’s views. Here they are: “RDS may never be this cheap again.” “The European Oil Major is well positioned.” “Shell is doing whatever it takes to maintain its dividend.” That last one should send up a dozen red flags: “whatever it takes” is a sign of desperation.
Today the shares are likely to go down in price by a dramatic amount. Why? Several reasons, but one is certainly that they cut their dividend. That is not a good sign.
One of my requirements of a dividend-paying investment is a rational payout ratio. The payout ratio is a simple calculation. The dividend payout ratio can be calculated as the yearly dividend per share divided by the earnings per share. Said another way, dividends divided by net income. If the company earned $1.00 per share, and they give their investors $0.35 per share in dividends, the payout ratio is 35.0%. That is a sensible ratio. Why? Because if their earnings drop to $0.80 per share, they have time to work on the business and don’t have to cut their dividend.
Dividend cuts are warning signs. If a company’s earnings are $0.50 and they are paying a $1.00 dividend, the payout ratio is 200%. You can’t pay more than you make for long. Your cash will dry up. Some companies will even borrow money to pay the dividend. That is like buying everything on credit. It will come back to bite you.
Let me encourage you to avoid any investment where the payout ratio is greater than 70%. That may be playing with fire. The exception is REIT investments and utilities. For REITs you also need to understand the “funds from operations” (FFO) metric. For utilities, a higher payout ratio of 80-95% may be acceptable. The reality is that I always want to see a dividend payout ratio between 20-70% for most other investments.