How to avoid the pitfalls when investing in the stock market and in particular in dividends

When you come across a company, it's a bit like when you meet a human being. We tend to form a fairly clear opinion of it very quickly. Sometimes it's right, but sometimes we're completely off the mark. One of the first aspects that poses a problem is its reputation. Obviously, the bigger the company, the more we are polluted by the image it gives off. Currently, for example, everyone only has eyes for Amazon. So yes, the growth in revenues, profits and the share price of this firm is impressive, but what guarantees us that this will still be the case in the future? Nothing. Profits are by nature fickle, today's winners are very often tomorrow's losers and vice versa. Despite this, everyone rushes to AMZN and does not hesitate to pay 75 times the earnings, in full euphoria.

It is difficult to keep a cool head. To do this, we must rely on a few factual elements that should allow us to question the dominant thinking and avoid the traps that are put in our way. In an ideal world, we would have to go through the financial reports from A to Z, look at each value, its evolution, read the footnotes, etc. However, we can already avoid many unpleasant surprises by keeping three crucial points in mind:

• The purchase price
• Liquidity and its flows
• Return to shareholders (based on fundamentals)

The purchase price

We are not going to repeat the whole explanation here on the valuation ratios. No matter how you look at the price, the important thing is to buy with a "margin of safety", according to the principles dear to B. Graham. Pricing a stock because it has incredible future prospects is pure speculation. What matters is what exists today. Facts. Paying 75 times Amazon's earnings when Bridgestone for example can be obtained for more than 7 times less, it is opening a bet on the future that only compulsive gamblers can make, not investors. By buying cheap, the chances of winning are high, just as the risk of loss is enormous if you buy too expensive. This seems obvious, but given the price increase of certain securities, particularly American ones, in recent years, it seems that the entire financial world is suffering from amnesia.

Liquidity and its flows

A company that does not generate money cannot pay its bills, taxes and employees. It is heading straight for bankruptcy. It is as simple as that. If current liabilities become greater than current assets, there is potentially a problem. The evolution of free cash flow is another crucial point. Like profits, FCF is inconsistent and can therefore fluctuate quite significantly from one year to the next. However, in the long term, it must be positive and have a favorable impact on cash reserves. A company that cannot generate FCF on a regular basis cannot pay dividends sustainably, cannot buy back shares and cannot invest in its own development. In other words, it cannot reward its shareholders. Profits are subject to accounting manipulation. FCF much less so. Rather than looking at the former, focus first on the latter. If the two do not evolve in the same direction, there is a problem. A company whose profit is growing while its FCF is flat is doing something wrong. April 2018 for example, I decided to part with one of my favorite titles, Bell Food (BELL:VTX), because the liquidity of the previous financial year was a problem for me (even though the profit had increased). My questions to the shareholders' department had not been able to obtain any information that could dispel my doubts. Moreover, the company's share price had already started to fall significantly, whereas it had only been increasing until then. Since then, the share price has lost almost 20%, with the figures for 2018 (published a year after my sale) reporting a drop in profit of 16.5%. This is just a small example, because sometimes the reaction time between FCF and profit is much longer. As the saying goes, "the longer, the better". Unless you are a shareholder!

Return to shareholders (based on fundamentals)

Historically speaking, nearly half of stock market gains come from dividends. The latter are living proof for the shareholder that the company's profits are real. Well, in most cases (we will see this point later). In addition, companies that have managed to increase their dividend for several decades have proven the viability and solidity of their business model, despite all the possible and imaginable crises they have faced. Making a result is good, perpetuating it over the long term and translating it for its owners is even better. This de facto excludes most startups and the eternal promises of Elon Musk. It also excludes companies that are too cyclical or that have been stagnating for quite some time. To pay dividends, you need strong kidneys, and therefore FCF as we saw above.

Be careful, however, with companies that pay juicy dividends. Unfortunately, this is often not a sign that the company is cheap, but rather that it is squandering its profits. Consider the equation: Payout ratio = PER x dividend yield. If the yield is 7%, even with a PER of 15 the profit would no longer be able to cover the dividend (payout ratio of 105%). If you buy a stock that pays such a yield, you have every chance in the world that it will be reduced, or even eliminated altogether, the following year. Not to mention that the price will have followed the same direction... Make sure to stay below a distribution ratio of 70%. But don't just look at the profits... remember what we said above about this. Also monitor the distribution ratio in relation to the Free Cash Flow, especially if it does not follow the same trend as the profits. No cash = no dividend! At least not in the long term.

Typically, the payout ratio of General Motors in relation to earnings is very good, with only 25%. However, GM has not been able to generate positive FCF for years, due to significant capital expenditures. So how come, you might ask, that this American automobile giant still manages to pay a dividend? The devil is in the details. The first thing that should make us prick up our ears is the dividend, which has not increased since 2016. A stagnation in distributions is often a good alarm signal. The other point is the debt, which has represented over the last five years an average negative annual return of -23.75% for the shareholder. This puts the current generosity of the dividend into perspective. Worse, it means that GM finances its distributions to shareholders by going into debt.

A company can therefore pay a generous dividend, even for several years, even when it does not generate any cash. It can do this by drawing on its reserves, by taking on debt or by issuing shares. Of course, in the long term, this is a strategy doomed to failure. So be wary of firms that:

• pay a dividend that is too generous compared to the market
• have been showing negative FCF for several years
• pay distributions higher than FCF over the long term
• see their cash reserves melt away
• have current liabilities greater than current assets
• have increasing debt over several years
• tend to issue new shares over time
• stagnate, decrease or cut their dividends

By keeping these questions in mind, you will save yourself a lot of hassle.