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Some clients may prefer easy investment strategies, such as focusing on a single metric like dividend growth. But, with most investment strategies, over- simplification can be a risky route, and the quest for dividend growth stocks is no different.

Even when a company increases dividends, its yield may not keep pace, making it less attractive in the end. For instance, Enbridge grew its dividend at a clip of 11% over the past five years, placing it in the top quartile of the S&P/TSX 60. But, its yield has fallen from an attractive 3.7% to a below- average 2.7%.

Besides yield growth, advisors should keep track of other matters when it comes to picking dividend growth stocks.

It wasn’t long ago that a number of income trusts flopped because they paid out too much of their cash flow as distributions (which made for attractive yields). Unfortunately, some of these companies didn’t save for hard times (e.g., cyclical construction businesses), and had to cut their distributions. But this can happen to any company, so the sustainability of dividends is an important factor.

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Advisors should be careful not to confuse consistent dividend growth with sustainability or relative attractiveness. Certain companies will tout the number of years they have consecutively increased their dividends. Fortis, for instance, says its dividend has increased for 41 consecutive years. While this is true, over the past five years dividends increased at a rate of just 4%, which is only the median performance of the S&P/TSX 60—not exactly the outperformance one might have expected.

A closer look

The most popular measure of dividend sustainability is the payout ratio, which is an approximation of how much cash a company is distributing versus how much it’s retaining for future dividends, investments, share buybacks or economic downturns. The numerator of the equation is relatively easy to figure out (dividends). Most analysts focus on dividends paid in cash, as opposed to those also paid in shares through a dividend reinvestment program.

The denominator is where the most disparity occurs. Using earnings or net income as the base is a problem, since large non-cash gains and losses create unwanted volatility. However, even adjusted earnings can be problematic, with accounting accruals distorting actual cash flows.

Companies will often choose the measure for investors, by providing the calculation of their own payout ratio in their quarterly reports. The best approach, probably, is to use free cash flow as the denominator—but check if a company has excluded normal operating costs or maintenance expenditures from its calculation of free cash flow.

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BCE, for instance, excluded $2.8 billion of regular employment expenses from its calculation of free cash flow over the last five years. The company then published a payout ratio for investors that was based on the larger free cash flow figure. BCE looked like it was paying out less of its cash to investors than it actually was (the payout ratio appeared more conservative). But, the real kicker was that BCE’s board used that lower payout ratio as the basis for increasing the dividend nine times over those five years.

There are two conclusions to draw from this.

  1. Aggressive financial reporting can influence cash flows and payout ratios.
  2. Actual dividend payments, and the dividend growth that some investors hold so sacred, might be based on manipulated numbers.

Since real cash is involved, BCE couldn’t continue to pay out more cash than it really had. Since the company had actually spent that $2.8 billion in the past on employment expenses, it needed to make up for that missing cash going forward in other ways. Management decided to do it through acquisitions.

BCE bought Astral Media in 2013, which was a good purchase for many reasons. It added roughly $215 million in annual EBITDA, and, more important to the company’s share price, the EBITDA derived from media assets is usually valued at a multiple of 10x.

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However, compare that to the next move BCE made, which was to buy the remaining interest in Bell Aliant that it didn’t already own. Despite having roughly six times the EBITDA of Astral, the transaction value for Bell Aliant was less than two times the former. The reason is that more than half of Bell Aliant’s revenue is derived from negative-growth legacy wireline assets—the type that typically trade at roughly 5x, or half of what media EBITDA assets are worth.

At this point, astute investors might question BCE’s overall strategy. Bell Aliant wasn’t a very attractive takeover target; nobody but BCE would have bought it. And, there are few redeeming qualities aside from one: even though those legacy assets are declining in value, they don’t require much reinvestment, which means most of the cash flow can be passed on to investors.

We believe BCE bought Bell Aliant mostly for the ability to distribute a greater proportion of cash flows and to keep increasing its own dividends, despite the fact that the move seriously impaired the company’s overall growth profile. BCE was already the Canadian telco most heavily weighted towards legacy assets. By adding Bell Aliant to the mix, the company’s expected trajectory got that much worse.

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Compared to BCE, Telus has shown a much more conservative payout ratio on an adjusted basis. No surprise, perhaps, that its share price has doubled the performance of BCE’s over the last three years, despite having lower dividend growth.

The bottom line is that picking dividend growth stocks is not a simple task after all. There can be a significant difference in the quality of cash flows that back up dividend increases.

Advisors have to ask themselves, what good is dividend growth if it comes at the cost of expected revenue growth, and ends up impairing the value of the company’s shares over the long run?

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge Report

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