Are These Blue Chips Going To Have To Cut Their Dividends Soon?

In the 1970s, investing maestro Charlie Munger was asked by a budding investment professional about what he could do to improve his skill set. Munger’s reply was to the point and profound: “Read history! Read history! Read history!”

History gives us context to understand what’s happening to the market. History can also tell us how and why things have gone wrong so that we can look out for the same signs in the future. As the 19th century American author Mark Twain once wrote, “History doesn’t repeat itself, but it does rhyme.”

Harbinger of dividend doom

I had recently chanced upon an earlier article from my U.S. colleague Brian Richards which detailed the lessons he had learnt from an old investment of his that had slashed its dividends substantially in 1995 and then further in 1997.

The company in question was Brown Shoe. In Brian’s article, he offered the company’s explanation for having to initiate that first dividned-cut (emphases are mine):

“The dividend had been increased or maintained for 20 years, and over the years had contributed very substantially to shareholder returns. But in recent years the dividend has principally been supported by cash flow from structural change — business sale or liquidation and plant closings.

The conclusion of these structural changes, difficult retail business and pressure on operating earnings in 1995 which was expected to continue into 1996, and the continuing high priority of protecting the balance sheet and our capability to finance the operation of the company, collectively made necessary the lower dividend.”

Brown Shoe had a remarkable track record of dividend growth over the past 20 years back in 1995. But, due to a lack of cash flow from its normal business operations, it couldn’t continue that winning streak.

Beware of a lack of cash

That’s an important lesson for investors who are looking for dividend investments: Focus on a company’s free cash flow. This crucial metric can be found in a company’s cash flow statement and it is simply the cash flow from the firm’s daily operations that are left after it has spent the necessary capital needed to maintain its businesses at their current state.

To drive home the importance of free cash flow, Brian continued in his article, stating that in “the two years before Brown Shoe cut its dividend for the first time, the company had negative free cash flow. The same was true in 1996 and 1997, just before the second cut came.”

Alarm bells are ringing

In Singapore’s parlance, a stock becomes a blue chip by virtue of its status as one of the 30 constituents of the stock market barometer here, the Straits Times Index (SGX: ^STI). For many investors, the ‘blue chip’ term also carries with it positive connotations.

But that does not mean the dividends of blue chips are guaranteed to be safe. Here’s a list of some blue chips that have been generating negative free cash flow over their last two fiscal years, according to data from S&P Capital IQ: Keppel Corporation Limited (SGX: BN4), Singapore Airlines Ltd (SGX: C6L), and Golden Agri-Resources Ltd (SGX: E5H).

Investors who are interested in them for their dividends (a stock such as Keppel Corp does have an attractive yield of 7%) would have to understand the risks involved.

A Fool’s take

None of the above is meant to say that the aforementioned blue chips are bound to face dividend cuts in the near-future. In fact, companies often make investments for future growth that can drive down current operating cash flow and free cash flow. If those investments are sound, then investors in such companies can even look forward to fatter dividend cheques in the years ahead.

That being said, when the free cash flow figure for your companies are negative, it’d pay for you to at least sit up, take notice, and figure out if there are any deep problems plaguing your investments.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.