3 Red Flags to Avoid for Dividend Stocks

By Markets Fool.com

Building a strong and durable portfolio filled with great dividend paying stocks is not just about knowing what to look for, it is also about knowing what to avoid.

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During my recent conversation with Jack Leslie -- current dividend and high-yield portfolio manager for Miller/Howard Investments -- he suggested there are three red flags he is constantly looking for:

  1. A high payout ratio
  2. Too much debt
  3. Slow growing dividends

As a portfolio manager for over 25 years, Leslie has found that by focusing on these indicators you can improve your odds of generating consistent dividend income and a better total return.

1. A high payout ratio
Companies have a long list of obligations: They need to pay employees, suppliers, taxes, and service debt. All of this comes before the company can pay dividends. As Leslie suggests, "We need to make sure that everyone else gets theirs, so that we can get ours."

To ensure companies can cover their dividend, Leslie focuses on the payout ratio. However, instead of using the normal metric -- dividends paid dividend by net income -- Leslie suggested, "We prefer to use cash flow to measure payout ratio rather than earnings. After all, dividends are paid in cash."

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As general rule of thumb, a payout ratio of more than 60% could put the dividend in jeopardy if the company's earning stumble. Although, there is certainly wiggle room here. For instance, companies with long and stable track records will often pay out a higher percentage of their cash flow, and more unique businesses like REITs, BDCs, and MLPs, will generally have higher payout ratios, as well.

What is important to remember is that as an equity holder, you get paid last. So, companies with high payout ratios are often more likely to cut their dividend, or have more difficulty growing their dividend.

2. Too much debt
For many investors, the financial crisis in 2008 and 2009 was a serious wake up call. Historically, companies could pile on debt assuming they would be able to refinance or push it back. In 2008, however, that changed. The credit markets froze, and lending halted. For many companies this created huge and immediate cash obligations.

To avoid these potentially vulnerable investments, Leslie suggests giving companies with higher leverage, especially higher levels of short-term debt, "special scrutiny."

Leverage is a measure of total liabilities (debt) to total shareholders' equity. A mortgage on a house is a good example. If you have a $90,000 mortgage on a $100,000 home, you have a debt-to-equity ratio of nine to one, or $9 of debt for every $1 in equity.

Leverage will vary by industry, but, in general, the higher a company's debt-to-equity ratio the greater the threat to the company's financial health. This is particularly true if that debt is short term (less than one year), because owing a lot of money five years from now, isn't nearly as bad as owing it tomorrow.

3. Low historic dividend growth
As Leslie suggested, "Dividend growth is an important component of total return: as the income stream from an asset grows over time, the value of that asset should grow, too."

It is a concept that can feel foreign with stocks, but it is a principal we readily accept with real estate. For instance: If you own an apartment building, and the average rent per unit increases from $500 to $700, because the asset is generating more income, you would expect the value of the apartment building to increase.

The same is true for stocks. As Leslie noted, it may not always happen in lock-step, but as the income stream increases, the value of that investment will grow.

However, when a company is not growing its dividend, the opposite is likely true. The company's earnings and their ability to generate cash is likely slower, and if the income stream is not growing then value of the asset is not likely to grow either.

Looking for obstacles
Finding great dividend paying stocks isn't easy, but as Charlie Munger famously said, "Invert, always invert: Turn a situation or problem upside down. Look at it backward."

By looking at an investment in reverse and focusing on what you need to avoid, you can efficiently narrow your search -- and, hopefully, find the best companies that will help to build your wealth over time.

The article 3 Red Flags to Avoid for Dividend Stocks originally appeared on Fool.com.

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