“If we look at cash dividends paid [by oil majors in 2007] divided by total net income, dividends appeared to be sustainable,” he expanded. “However, free cash flow conversion was roughly half of total net income – from almost $90bn, there was only around $40bn of free cash flow to pay shareholders.
“This was when oil was trading at $100 per barrel – the operating leverage for oil companies when oil drops to below $60 per barrel is enormous, and they lose more than one-for-one on free capital. Dividends are unsustainable, and people are investing in the headline yield without thinking about where it is coming from and where it will go.”
Don’t walk on the grass
So where do income investors go from here?
Lowry has one somewhat unorthodox solution, suggesting that investors go against their inclinations and look at mechanics of companies that have either recently or are in the process of cutting their dividends.
“A company that cuts its dividends has a better financial profile than it did previously,” he said. “If it cuts its dividend then that means there is something going wrong in the business, but if it stops promising to pay out that level of dividend, by definition there is a better starting point for an investor.
“The last thing that chairmen want to do is cut dividend – the day they do that, their job is at risk. Dividend cuts often accompany the exit of the CEO, CFO and chairman, so there are three characteristics of this company – cheaper shares, a better financial profile and a new management team coming in to sort out the problems. But the problem is that it is surrounded by this dividend-cutter’s worry.
Lowry continued: “However, if you invest in a stock that has cut its dividend, it takes around 18 months to two years on average for that dividend to be reinstated. The statistics say that after that period the firm has usually got over the hump of its problems, and the growth it sees from that point is far superior to the market. This is what makes dividend-cutters an interesting place to look.”
