Why cash flow is key to dividend investing

On July 7, 2008, the S&P 500 crossed the threshold into bear market territory, having slid 20% from its high on October 9, 2007.

Today [Oct 30] the S&P is trading at 935 - a 40% drop from its high of 1,565.15. If you take the 14 bear markets since the Great Depression, the average decline was 38%. At the low on October 28, the decline was 45.5%.

So are we at the bottom? Perhaps. But consider this...

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The average duration of these bear markets was 18.4 months. Given that we're in the 13th month now, that puts us relatively close to the end, right?

Not quite. Bear markets aren't created equal and if you only take the ones that saw declines in excess of 40%, the average duration is 28.4 months.

So if the current bear plays out in this way, we aren't even half way through. Combine this with an unemployment rate of 6.1% - with the expectation that it will rise above 7% - and it seems much less likely that we've reached the bottom.

What does seem certain, however, is that we're likely in for a long recovery, which could substantially jeopardise cash flows. And that's a key issue when it comes to investing in companies on the basis of a dividend.

Dividend investing: to pay or not to pay?

Amid the market's mess, many pundits have touted the benefits of dividend-paying stocks. It's an issue we wrote about here a couple of weeks ago.

While it's true that dividends bring you a form of income, does it really put a floor under a stock? The argument is pretty simple. Many companies have products that are such an integral part of day-to-day life that they are:

1. Very unlikely to disappear.

2. They've built up balance sheets that are strong enough to survive a multi-year downturn.

So instead of high share price appreciation, they repay their shareholders by passing along the profits in the form of dividends.

However, as cash flows dry up, companies cannot always support their dividends and investors can suffer a second whammy as the dividend gets cut and the stock finds a new level at the same yield.

Here's the way to do it...

Dividend investing: follow the cash

You have to be tactical. Buying dividend stocks in this type of prolonged downturn does provide a good return if the stock remains stable. But if a cash flow shock occurs, dividends could suffer and the stocks that were supported at the beginning of the bear market substantially underperform later on.

You can avoid this trap by looking at the key driver of dividends - cash flow.

In the heat of a bear market, investors will always be concerned about how far top-line growth can drop, but good management teams can handle this by cutting expenses.

However, the fixed depreciation of hard assets that are stuck to the balance sheet can make profit look worse than cash flow. While profit may look bad in the short-term, I have never seen a company cut a dividend that was 50% of free cash flow (or less).

The bottom line is that as long as free cash flow holds up, the management team has options and the dividend will be safe.

The last thing a company with a historically stable dividend will do is cut its dividend, as it would entirely change the shareholder base by boxing out value investors that have a yield hurdle.

So when it comes to dividend-paying stocks, while revenue and earnings growth are obviously important, be more concerned with the money on the cash flow statement.

This article was written by Paul Moore, contributing editor & technology specialist at the Smart Profits Report