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Weird Oil Prices And The Search For High Dividends
By now you’ve heard that in some places in the world, interest rates have turned negative. When interest rates are negative, it means you can borrow money and receive interest payments from the bank instead of paying interest. I know it sounds crazy and it is crazy—a crazy, messed-up thing. But now because of Covid-19, something crazier just happened. It’s called negative oil prices.
That’s right, the price of oil went below $0. Essentially, it means that a seller of oil, like the US or Saudi Arabia, Russia and others, could actually pay the buyer to take possession of the oil. It’s like filling up your tank at the gas station and getting paid to do it. Crazy! How could this happen?
Oil Surplus Meets Covid-19
Well, it seems the world is running out of places to store all the excess oil that continues to build up. The excess continues to rise because production has remained strong just at the time demand has fallen off a cliff. All the storage tankers are filling up, all of the ships with tanks to hold oil are filling up, and even though Russia and Saudi Arabia have come to an agreement to start reducing their output in May, demand is so incredibly weak right now that it has created this whopping excess. It’s another example of the unexpected effects brought on by an unprecedented viral calamity.
One trader, writing in Forbes Magazine blamed the sharp drop on an exchange-traded fund with the symbol USO that holds oil futures in its portfolio. His reasoning had to do with an anomaly in the way the monthly contracts traded.
So, oil has become incredibly volatile, just like the stock market. In early March, oil prices had fallen 75% since the beginning of the year, and as I just mentioned, even went negative for a brief period of time.
Last Thursday though, oil rebounded by 20%, but it did little to erase the losses since the beginning of the year. The two most important issues going forward will be the reduction in production in an attempt to balance the supply with demand, and also to see demand rise to meet supply. Both are very far apart right now, and it will take dramatic cuts in production to bring them in line. There is movement, however, because according to some reports, we are starting to see major cutbacks in production right now. Let’s keep an eye on this one.
Re-Thinking Dividends
Another theme I want to examine today is the question of dividends. Dividends are a very important source of income for investors and also represent a good percentage of the stock market’s historic rate of return. As companies experience significantly lower profits though, the portion of those profits that come to us as dividends may be affected.
It makes sense that companies losing billions of dollars are going to drastically reduce, suspend, or eliminate their dividends. And that’s exactly what is happening in some industries.
Some companies that have already suspended dividend payments are Ford, Delta, Carnival Cruise Lines, Las Vegas Sands, Marriott, Macy’s, just to name just a few.
According to Goldman Sachs, the money paid to shareholders as dividends will likely be reduced by 25% in 2020—and that’s an average of the S&P 500.
So which industries do you think will cut their dividends?
1. Energy, for one, based on oil at $20/ barrel.
2. Entertainment—which, with the exception of streaming, has basically disappeared.
3. Travel—there is none.
4. Restaurants—all closed.
5. Retailers with stores—I don’t have to explain that.
Choosing those were pretty obvious. We can see that all around us.
But what about bank stocks with the possibility of tons of bad loans? What about real estate with people deferring their rent or working from home? Will they ever go back to offices? Nursing home stocks with coronavirus protection issues? Will each of these challenged entities pass through their suffering by lowering their dividends to shareholders?
Well, the answer lies in the details, my dear. Some will and some won’t. The key will be to figure out which companies within those industries are in good financial shape and which are not!
Goldman’s report lists about 40 stocks from 10 industry sectors they believe will be able to maintain their dividends. Out of the 40, 13 are financial companies, 7 are industrials, 5 utilities, 3 from real estate, 3 from health care, and 3 from info technology, 2 from consumer staples, and 1 from communication services.
Let’s take a look at one of companies on Goldman’s list. It’s a major money center bank of the “too big to fail” variety. It was down 41% year-to-date as of March 30TH and still has not come back all that much. It has $11 of assets to every $100 of liability, which doesn’t sound like much but in the banking business, a 1 to 10 ratio is considered to be sound banking. It pays 47% of its earnings as a dividend and if their earnings get walloped by 33%, the payout ratio would jump from 41% to 71%—still leaving ample room for more negative surprises.
Here’s the interesting kicker. Current annual dividend yield is around 7%.
Now generally, it’s not a good idea to be sniffing around companies just because they have a high-dividend rate. Often it is a sign that the steep reduction in the share price is predicting some invisible problem, so comparing that low price to a dividend that was paid out over the last 12 months could be a big mistake. It could mean the market thinks there is a dividend cut coming.
Maybe the market thinks this is so with this big bank but after Goldman ran its numbers, it doesn’t think so. Of course, Goldman can be and is often wrong in its predictions, so caveat emptor, please. However, it makes for an interesting situation and a possible opportunity.
A Close Assessment Is the Best Defense
So, the key to this list of Goldman’s or any list you might devise yourself will be your ability to take a close look at the company you want to buy and treat your decision seriously—as seriously as if your life depended on it.
You’ll want to look at things like:
1. Does it have enough cash on hand to weather this storm?
2. Does it have a good rating so it can borrow money at decent rates if things continue to degrade?
3. Are its operations efficient?
4. Does it have stable cash flow?
5. Will their cash flow still cover the dividend in a worst-case scenario?
Hey, this is the fun part of investing—learning what makes a business tick and learning how to value a business so you pick the price you want to pay.
But it also takes plenty of knowledge, both cerebral and emotional. So, if you’re up to it, great! If not, consider some exchange-traded funds that have created their own list of criteria for buying excellent companies with higher than average dividends. There are plenty of those funds out there. Or if you want to be even more careful, talk to an advisor.
Either way, you may be able to find companies paying north of 4% which is so much more than fixed-income investments. And maybe as an added bonus, you may also enjoy dividend increases when this crisis is finally over.
Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. There are no investment strategies that guarantee a profit or protect against loss. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however, their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by the radio show.
