Thursday, August 20, 2009

* Industrial Strength Dividends

This is a guest post by Saj Karsan of Barel Karsan. Saj is a DIV-Net core members and a value investor.

One of the biggest fears of the dividend investor is that a company with an attractive-looking yield will cut its distributions to shareholders. While there are certain early warning signals on a company level that may indicate that the risk of a dividend cut is high, investors should also be aware that the risk of a distribution cut is higher in some industries than it is in others.

To understand this phenomenon, it is important to realize that some industries are more cyclical than others. What this means is that during recessions, some industries (e.g. many grocery goods) won't see demand drop as much as others (e.g. housing) will. As such, during long periods of economic malaise, companies in stable industries are better equipped to maintain dividends.

Furthermore, the cost structure of an industry will also dictate a company's ability to steadily manage its dividends. When demand drops (as it invariably does during recessions), companies with high fixed-costs will find themselves bleeding cash, while those with flexible cost structures can quickly and easily bring costs down such that they are back in line with revenues, reducing the risk that dividends will have to be cut.

As an example of how important an industry's role can play in determining a company's ability to pay dividends, consider the airline industry. Demand for air travel is highly cyclical, as recessions cause weary consumers and businesses to scale back travel plans. Further exacerbating this situation is the fact that fixed costs for airlines are high, as aircraft leases cannot simply be cancelled, and labour and equipment costs for a given flight cannot simply be cut (i.e. if a plane is half full or passengers are paying reduced fares, costs cannot be materially reduced to compensate). As such, the profit levels of airlines fluctuate dramatically, resulting in high risks for the dividend investor.

While the risk of a dividend cut for any company in any industry is always present, investors who recognize which industries are the least cyclical, and which have most flexible cost structures, put themselves in a position to avoid a negative surprise when economic troubles occur.
Saj Karsan is the author of Barel Karsan, a site dedicated to finding and discussing current value investments. Readers can subscribe to the site's feed here.