No. of Recommendations: 21

Why Investors Should Be Cautious Of 'Artificial' Dividend Growth

In a broad sense, the basic premise of this article is sound. Avon had to cut its dividend because it wasn't sustainable given their troubles. Water under the bridge. However, I would quibble with the author's other examples of potentially endangered dividends.

Waste Management (WM). In my opinion, the author is on the right track, sort of. It's true that while the dividend has been increasing earnings haven't kept up. However, what he hasn't accounted for are extraordinary loses or gains, if he had the earnings he quoted for 2011 would have looked better. I think it's worth noting too that, in spite of earnings that have stagnated the dividend is still covered and then some by free cash flow. Meaning the company can afford to pay all its capital expenses, it's dividend, and retain some earnings. This is a far cry from the situation Avon was in. Earnings for 2013 are projected to be higher and at this juncture there's every reason to think that they will rise modestly, perhaps at 5% and the dividend is likely to rise at the same rate.

Johnson & Johnson (JNJ). This author isn't the first to be skittish about Johnson & Johnson, but, in my opinion with little reason. One flaw in his argument is, again, not taking into account nonrecurring expenses, gains, or losses. If he had J&J's earnings have increased each year. J&J's capital needs are proportionally less than Waste Management's which leaves them ample free cash flow with which to cover their dividend. In fact they could pay the dividend nearly two times over from their free cash flow, even without taking into account nonrecurring expenses. It's true that the pay-out ratio has ticked up over the years, but on an adjusted earnings basis it's still less than 50%. Dividends are likely to grow in line with earnings going forward. For what it is worth Value Line gives J&J a Safety Ranking of 1 (highest) and a Financial Strength Ranking of A++ (highest). Morningstar describes the company as an exceptional cash-flow generator. If you hold J&J for its dividend I think you can continue to sleep well at night.

In my opinion, if a company can more than cover its dividend from free cash-flow and retain earnings then there's likely not much chance that the dividend is in jeopardy, or destined for a haircut. However, companies that appear to have stagnating or declining earnings and continue to raise their dividend bear a little investigation. In my book Waste Management and Johnson & Johnson both pass scrutiny, with J&J coming out on top.

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