2023-05-30 12:48:00 ET
Summary
- There are many reasons why “dividend traps” cut or suspend their dividends, but one common reason is that they have too much debt.
- The main risk that comes with having too much debt is that the interest payments will become unaffordable if the company's profits decline for one reason or another.
- Cyclical companies operate in industries that go through cycles of boom and bust while defensive companies operate in industries where the ups and downs are far less pronounced.
As a dividend investor I'm looking to invest in good companies with high yields, but in most cases high yields are only available when investors are pessimistic about a company's prospects.
If investors are right to be pessimistic, an alluringly high yield may turn out to be a mirage that disappears when the company suspends its dividend. Even worse, a high yield could be a siren call that lures unwary investors into a stock that is about to go to zero.
There are many reasons why these “dividend traps” cut or suspend their dividends, but one common reason is that they have too much debt. The obvious way to avoid that risk is to only invest in debt-free companies, but that isn't always the right answer either.
In my experience, there is a sweet spot between having no debt (which reduces risk but also reduces potential returns) and having too much debt (which increases potential returns but also increases risk), and in this post I'll explain the two ratios I use to identify companies operating in that sweet spot.
Note: This is the fifth in a series of blog posts where I take a detailed look at how I’m investing in quality dividend stocks for long-term income and growth. The last post looked at how to find quality dividend stocks using two profitability ratios .
Measuring the risk of a debt default
The main risk that comes with having too much debt is that the interest payments will become unaffordable if the company's profits decline for one reason or another. Lenders are aware of this, so they’ll often attach covenants to loans, which are contractual obligations that the borrower must stick to.
Typically, debt covenants stipulate that the borrower must keep the ratio of profit to interest or profit to debt above a certain level. If the borrower breaks these covenants, the lender can take various actions, such as demanding full repayment within a relatively short period of time.
When I’m looking at a company’s debt profile, I look at it from the point of view of a lender because I’m interested in the same thing as a lender:
I only want to put my money into companies that can easily afford the interest on their debts and easily repay their debts in good times or bad.
Comparing total debt to average earnings
There are many debt ratios to choose from, but I use the ratio of total debt to average earnings:
- Total debt = Borrowings + lease liabilities
- Average earnings = ten-year average post-tax profit
- Debt ratio = total debt / average earnings
This ratio tells me, approximately, how many years it would take a company to pay off all borrowings and lease liabilities if it continued to generate historically average earnings.
I wrote about lease liabilities at length in the previous post on profitability ratios , but as a quick reminder, they are effectively a form of debt, where companies borrow stores or other property from landlords.
Most debt ratios compare debt to last year’s earnings, but earnings can vary a lot from one year to the next, so these ratios can give misleading results. To avoid the negative impact of earnings volatility, I compare debt to earnings averaged over ten years, and you can think of this as a relatively conservative estimate of “normal” earnings.
For high-growth companies, that estimate of normal earnings will be even more conservative because their ten-year average earnings will be much lower than their current earnings.
This additional conservatism with high-growth companies is deliberate because debt tends to exacerbate other risks, and faster growth usually comes with higher risks (in the same way that faster driving usually comes with higher risks).
I refer to this ratio as debt-to-average earnings ratio, the cyclically adjusted debt ratio or just the debt ratio. As with all of my metrics, I have a related rule of thumb, but in this case the rule varies depending on whether the company is cyclical or defensive.
Defensive stocks can safely carry more debt
In simple terms, cyclical companies operate in industries that go through cycles of boom and bust while defensive companies operate in industries where the ups and downs are far less pronounced. This has clear implications for the amount of debt these companies can safely hold.
A defensive company, with relatively stable revenues and earnings, will be able to take on more debt because its earnings are unlikely to fall very far during a recession or other downturn. On the other hand, a cyclical company won’t be able to carry as much debt, at least if it wants to avoid defaulting on its debts during the next recession.
Accurately defining a company as cyclical or defensive can take a bit of investigation, but an easy first step is to look at the company’s ICB sector (ICB stands for Industry Classification Benchmark). This is a widely used categorisation system that you’ll find it on most stockbroker websites, usually alongside other information such as the company’s name, market cap, index and so on.
Here’s a list of all the ICB sectors and their defensiveness:
Defensive sectors :
- Aerospace and Defense
- Beverages
- Electricity
- Food Producers
- Gas, Water and Multi-utilities
- Health Care Providers
- Medical Equipment and Services
- Non-life Insurance
- Personal Care, Drug and Grocery Stores
- Personal Goods
- Pharmaceuticals and Biotechnology
- Renewable Energy
- Telecommunications Service Providers
- Tobacco
Cyclical sectors :
- Automobiles and Parts
- Banks
- Chemicals
- Consumer Services
- Electronic and Electrical Equipment
- Finance and Credit Services
- General Industrials
- Industrial Engineering
- Industrial Materials
- Industrial Support Services
- Industrial Transportation
- Investment Banking and Brokerage
- Leisure Goods
- Life Insurance
- Media
- Retailers
- Software and Computer Services
- Technology Hardware and Equipment
- Telecommunications Equipment
- Travel and Leisure
- Waste and Disposal Services
Highly cyclical sectors (I usually avoid these):
- Construction and Materials
- Household Goods and Home Construction
- Industrial Metals and Mining
- Non-Renewable Energy
- Oil, Gas and Coal
- Precious Metals and Mining
Having categorised a stock (at least initially) as defensive or cyclical, I can then apply the following rules of thumb:
- Rule of thumb : Only invest in a defensive company if its debt ratio is below five
- Rule of thumb : Only invest in a cyclical company if its debt ratio is below four
- Rule of thumb : Only invest in a highly-cyclical company if its debt ratio is below three
The last rule is somewhat redundant as I try to avoid highly cyclical companies, but it’s there just in case.
Let’s take these ideas and apply them to a well-known company that is currently in the UK Dividend Stocks Portfolio .
Next is a retailer with surprisingly little debt
Next ( NXGPF )( NXGPY ) is one of the UK’s leading clothing and homewares retailers and I used it as the example company when I wrote about my profitability ratios. Next still has a significant number of physical stores, so it should be an interesting example as it has a meaningful amount of both lease liabilities and borrowings.
To calculate the debt ratio, we need earnings (net profit, which you'll find on the income statement), borrowings and lease liabilities (which you'll find on the balance sheet).
Looking at the raw numbers, Next currently has:
- Borrowings of £893 million
- Lease liabilities of £1,023 million
- Total debts of £1,916 million
- Ten-year average earnings of £598 million
This gives Next a total debt-to-average earnings ratio of 3.2.
Clothing and homewares retail are cyclical, so my rule of thumb says the ratio should be below four, which it is.
This means that Next is taking the opportunity to accelerate growth and returns using debt, but it is doing so in a conservative and prudent manner.
The company’s relatively small lease liabilities are particularly interesting, as this is one area where many store-based retailers go wrong.
Weak retailers will often try to improve their weak profitability by reducing their monthly lease costs, and one way to do that is to sign very long lease agreements. Landlords are happy to charge lower rents in exchange for locking in a tenant for ten or 20 years, but this also locks the retailer into a fixed store estate that cannot easily be adapted to a rapidly changing world.
In contrast, high-quality retailers with high profitability can afford higher rents, so they can sign leases that are much shorter and more flexible. In Next’s case, its outstanding lease commitments extend a mere 4.7 years into the future and more than 91% of its leases will expire in less than ten years.
This is good news for Next, but there are very few store-based retailers that can match Next for profitability, so most of them have much larger lease liabilities.
There is a risk that my debt limit of four times average earnings for cyclical companies may exclude other high-quality retailers that are not quite on a par with Next, at least in terms of debt. One of my ex-holdings, Burberry (BURBY), is a good example, as it is undoubtedly a very high-quality retailer but it also has a debt ratio of 4.5.
Having followed Burberry closely for several years, I don’t think that level of debt is excessive, so I use another rule for store-based retailers that allows them to carry slightly more debt:
- Rule of thumb : Only invest in a store-based retailer if its debt ratio is below five
Returning to Next, the company clearly has very little debt for a retailer, but has that always been the case? Perhaps last year was an anomaly where its debts were unusually low and perhaps they’ll rebound to unacceptable levels within a year or two?
That does sometimes happen, so it’s useful to look at how a company’s debts have evolved over time.
To see if this is the case with Next, here’s a chart of its debts over the last decade.
Data source: SharePad
Note: The sharp drop in lease liabilities between 2017 and 2018 is misleading because it reflects a change in accounting rules rather than an actual change in the company’s leases (for the gritty details, read up on IFRS 16 ). Also, lease liabilities weren't recorded on the balance sheet before 2018/2019. Instead, you'll find them in the back of each annual report in a table called "operating lease obligations" or similar.
The chart shows that Next’s debts have been declining fairly steadily in recent years, even though the company has been growing its revenues and earnings.
Its lease liabilities have declined because, like most retailers, Next has spent the last few years shrinking its store estate as the world rapidly shifts from in-store to online shopping, and fewer stores obviously means fewer leases.
In addition, a reduction in demand for physical stores across the UK has led to a reduction in rents. Last year, for example, Next saw rent on renewed leases fall by an average of 30%.
In summary then, Next has very little debt and its debts are falling while the company is growing, which is a very attractive combination.
Taking account of defined benefit pension risk
Defined benefit pensions are another form of debt, at least for companies that offer them (many companies only offer defined contribution pensions, which I don’t care about because they’re relatively risk free from the company’s point of view).
Defined benefit pensions offer employees a pension that is typically based on their salary. As employees toil away each month, the employer and/or employee will put a small amount of money into the pension pot, building up assets that will be used to fund pension payments in the future.
This means that defined benefit pension schemes have assets (employee/employer savings) and liabilities (the expected future pension payments) and both are recorded in the accounting notes the back of each annual report.
Ideally, there will be a small surplus of pension assets over pension liabilities, which means the pension scheme is “fully funded”. But this isn’t always the case. Sometimes, a pension scheme’s assets will be smaller than its liabilities, which means the scheme is in deficit and this is where the problems begin.
If there is a pension deficit, the company is legally obliged to reduce that deficit, usually by injecting cash into the pension fund. For practical purposes then, pension deficits are just another form of debt that has to be repaid.
To take account of this, I always check to see if a company has a defined benefit pension scheme and a related pension deficit. If it does, I’ll include the pension deficit in the company’s total debts and recalculate its debt ratio.
As an additional sanity check, I also look at the overall size of the pension liabilities. I’ll do this even if there is no pension deficit, because although a pension scheme may be in surplus today, it might not be tomorrow, and the potential size of a future deficit will be directly related to the overall size of the scheme’s liabilities.
More specifically, I compare a company's pension liabilities to its ten-year average earnings, and I call this the pension to average earnings ratio or just the pension ratio.
- Pension ratio = pension liabilities / average earnings
My rule of thumb for the pension ratio is simple:
- Rule of thumb : Only invest in a company if its pension ratio is less than ten
Next has a small defined benefit pension scheme that doesn’t have a deficit, so it doesn’t make for a very interesting example. Instead, I’ll use BT as an example because the BT pension plan is enormous.
BT has a supermassive “pension black hole”
BT ( BTGOF ), as you probably know, is one of the UK’s leading telecoms companies and for most of its history it was a state-owned monopoly. State-owned entities often give their employees defined benefit pensions and that is the case with BT, which has a pension plan with around 270,000 members.
BT has a pension deficit of £2.5 billion compared to its ten-year average earnings of £1.9 billion, so the deficit will have a noticeable impact on the company’s debt ratio, which is already very high.
More specifically, BT has borrowings of £18.5 billion and lease liabilities of £0.5 billion, giving the company a total debt mountain of £23.9 billion. With average earnings of less than £2 billion, that gives BT a sky-high debt ratio of 12.6 and we haven't even included the pension deficit yet.
If we include the pension deficit, then BT’s total debts balloon to £26.4 billion and its debt ratio reaches a near-ridiculous 13.9.
Telecoms is a defensive industry so I would be willing to accept a debt ratio of anything up to five, but BT is clearly a long way past that threshold.
But perhaps this is an anomaly, where last year’s exceptionally high debts don’t reflect the long-run trend?
Sadly that is not the case, as BT (unlike Next) has seen its revenues and earnings fall over the last decade while its debts have grown.
This has, of course, produced a gradually rising ratio of debt to average earnings.
So, in addition to having too much debt, there has been an upward trend in BT’s indebtedness over the last decade and that may not bode well for the future.
As for the BT pension plan's overall liabilities, they stood at £42 billion in March 2023. That gives BT a pension ratio of 22, which is more than double my limit of ten.
Amazingly enough, that is actually a marked improvement from the previous year where BT’s pension liabilities stood at an astonishing £54 billion, or almost 29 times its average earnings (and three times my limit).
With such an enormous pension scheme, there is a serious risk that BT will have to inject vast amounts of cash into it to make good on its pension obligations, and this is already happening.
For example, in recent years BT has funnelled about half of its earnings (about £1 billion per year) into its pension scheme to reduce the deficit and this level of funding is expected to continue for another ten years or so.
This means that BT’s primary purpose is to generate cash for its pension members rather than its shareholders, which perhaps explains why the dividend of this supposedly defensive business was suspended in 2020 and why it has yet to return to anything like its pre-pandemic high.
Summary: Beware of excessive debts and pension liabilities
In summary then, the main forms of debt are borrowings, lease liabilities and pension deficits. These are sources of funding that can act like rocket fuel, dramatically speeding up a company’s ascent, but rockets sometimes explode and that’s also true of companies that use too much debt.
Although excessive debt is a serious problem, a debt-free balance sheet isn’t optimal either. Instead, most high-quality companies operate in the sweet spot between too much debt and too little, and in my experience, that sweet spot is usually covered by these rules of thumb:
- Rule of thumb : Only invest in a cyclical company if its debt ratio is below four
- Rule of thumb : Only invest in a defensive company (or a store-based retailer) if its debt ratio is below five
- Rule of thumb : Only invest in a company with a defined benefit pension if its pension ratio is below ten
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
For further details see:
How To Avoid Dividend Traps With Excessive Debts