Dividend Safety Scores: A Review of 2016

One of the most important components of Simply Safe Dividends is our Dividend Safety Score, a metric that rates the safety of a company’s dividend payment by scrubbing through its most important financial metrics.

Dividend Safety Scores are available on our site for thousands of dividend-paying stocks and can help you avoid riskier investments and build a more resilient income stream. You can read more about how our scores are calculated and view their real-time track record by clicking here.

Dividend Safety Scores range from 0 to 100, and I usually suggest that conservative investors focus on stocks that score at least 60. Scores can be interpreted as follows:

As you know, I believe in complete transparency in all that I do. From reporting detailed performance information about our dividend portfolios each month to owning up to investment mistakes I make (and there will certainly be more), I will always do my best to tell it exactly how it is.

The only way to grow as an investor is to be open and honest with ourselves, tracking and analyzing our entire decision-making process and the results we achieve (good and bad) in order to continuously improve. If we give into human temptation to ignore our investment mistakes, we do ourselves a great disservice and are more likely to make the same errors over and over.

The same is true for our Dividend Safety Scores. Instead of blindly shoving thousands of scores out there on the website and hoping they have some meaning behind them, I track their performance in order to gain powerful insights that can be used to make our scores even smarter as time goes on. I know many of you rely on Dividend Safety Scores to help guide your investment decisions, and I take your trust in our metrics very seriously.

By logging real-time dividend cut announcements and recording the Dividend Safety Score we had for a company right before its dividend reduction was reported, we can view the effectiveness of our Dividend Safety Scores, learn more about why companies cut their dividends, and discover ways to further improve the risk assessment capabilities of our scores.

We began tracking all dividend cut announcements in April 2016 (see them all here). The chart below incorporates data recorded over the last year, plotting each company’s Dividend Safety Score on the x-axis and the size of its dividend cut on the y-axis.

Two observations jump out at me. First, all but one of the companies cutting their dividends scored close to 40 or below for Dividend Safety, falling in the “Unsafe” and “Extremely Unsafe” buckets. The one exception was a micro-cap stock (Ecology and Environment – EEI) that scored an 82 for Safety.

How did this happen? The company’s fundamentals were actually very healthy, but management decided it wanted to invest more for growth, freeing up additional cash for reinvestment by reducing the dividend by 17% (read the company’s press release here).

I am not really sure there was much we could have done to flag this dividend cut ahead of time since management’s decision to reduce the dividend had little to do with the company’s actual fundamentals (e.g. payout ratios, earnings growth, balance sheet, dividend longevity etc.). However, we do treat micro-caps with greater conservatism today in recognition of their generally more dynamic capital allocation policies.

The second observation from the chart above is that companies with lower Dividend Safety Scores were more likely to cut their dividends by larger amounts. You can see that most of the biggest dividend cuts (e.g. 50%+) happened with companies scoring below 10 for Dividend Safety.

Of course, not all companies that score low for Dividend Safety are at risk of an imminent dividend cut. In fact, most years there are relatively few dividend cuts compared to the number of dividend-paying stocks in the market. For example, only a dozen S&P 500 companies reduced their dividends in 2007, and just four slashed their payouts in 2010.

However, during the financial crisis (2008-09), roughly one-third of dividend-paying companies in the S&P 500 cut their dividends. Dividends generally rise over long periods of time, but the periods marked by heavy dividend cuts are usually steep and come with little warning.

Companies that score below 40 for Dividend Safety are likely the most vulnerable to slashing their dividends during the next recession. No one knows when the next crash is coming, and many economists don’t even realize that we are in a recession until it has already set in.

I prefer to remain conservative with our Dividend Safety Scores and will continue rating potentially problematic companies low for Dividend Safety, even if their dividends could remain safe until the next recession. It’s better to be aware if a company’s dividend has high risk potential before something bad happens, in my opinion.

To that point, I have some additional data on Dividend Safety Scores to share. Companies that are at greater risk of cutting their dividends usually have a number of problems. From too much financial leverage to unsustainably high payout ratios and slumping earnings, there is no shortage of potential issues.

Many of these financial problems are not only bad for the dividend’s safety, but also for the entire company in general. Many of us are conservative investors who are looking to not only generate safe, growing dividend income, but also preserve capital.

Even if the dividend remains safe, many of these low-scoring stocks can be very toxic investments that permanently destroy our capital. A “safe” dividend does little good if the stock’s price declines by 50%.

The table below takes a few minutes to digest, but it’s very important to understand. At the start of 2016, I recorded the Dividend Safety Scores of every stock in our database and placed them into the five groups below based on their scores.

Each group contained close to 400 stocks. I then recorded the total return of each stock in 2016 and calculated the following statistics:

• Average Return: the average 2016 total return of all stocks in each group.

• Minimum Return: the lowest 2016 total return recorded by a stock in each group.

• Maximum Return: the highest 2016 total return recorded by a stock in each group.

• % of Stocks With a Negative Total Return: the percentage of stocks in each group that recorded a 2016 total return below 0% (i.e. these stocks lost money for investors in 2016).

• Standard Deviation: measures the volatility of all of the individual stock returns in each group. Lower figures indicate milder price swings and a smaller chance of sharp declines.

• Average Beta: the average beta across all stocks in the group at the start of 2016. Beta is the volatility of a stock compared to the market (<1 = less volatile; >1 = more volatile).

• # of Stocks: the number of dividend stocks in each group at the start of 2016.

The first figure that really jumped out at me was the average return of each group. Stocks with a Dividend Safety Score below 20 at the start of the year had an average total return of -2% in 2016. They lost money on average despite the S&P 500 returning over 10%!

Over half (53%) of the 431 companies in this group recorded a negative return in 2016. The odds were not in your favor trying to picking safe dividend stocks from this bucket.

On the other end of the spectrum, stocks with Dividend Safety Scores between 61-80 and 81-100 achieved an average return of 22%, and less than 25% of these stocks recorded a negative total return in 2016. In other words, sticking with stocks that scored higher for Dividend Safety gave a much better chance of earning a meaningfully positive return.

Higher Dividend Safety Scores also did a good job of weeding out the stocks most likely to blow up. The worst-performing stock with a Dividend Safety Score over 80 delivered a -42% return compared to -74%, -88%, and -99% minimum returns in the Average (41-60), Unsafe (21-40), and Extremely Unsafe (0-20) buckets, respectively.

Not surprisingly, stock price volatility was the lowest (28% standard deviation) in the Very Safe (81-100) bucket of Dividend Safety Scores and highest (41% standard deviation) in the Extremely Unsafe (0-20) bucket. Healthy companies with safe dividends tend to have fewer nasty surprises, resulting in less stock price volatility and better capital preservation.

To conclude, data from 2016 suggests that the application of Dividend Safety Scores extends beyond a pure measurement of how safe a company’s dividend is. Dividend Safety Scores acted as a good overall measure of business quality and investment risk. Very conservative income investors have little to no business reaching for stocks that score below 20 (or even 40) for Dividend Safety.

However, these insights aren’t worth much if they aren’t actionable. With the start of a new year and the market sitting near an all-time high, now is as good of a time as any to review your portfolio for Dividend Safety and overall quality (especially for those living off dividends in retirement).

As the ancient philosopher Lao Tzu said, “Do the difficult things while they are easy and do the great things while they are small. A journey of a thousand miles must begin with a single step.”

You can use our Portfolio Analyzer tool to view Dividend Safety Scores for each of your holdings and your overall portfolio by clicking here. Even if you don’t see a need to make any changes, it is important to stay on top of this information and be aware of the risks you are taking.

You can also use our Stock Analyzer tool to retrieve Dividend Safety Scores for thousands of stocks to evaluate ideas you get from our site or other sources.