Should Companies Tie Dividends to Cash Flow?

In a recent Barron’s interview, Goldman Sachs global co-head of single-stock research Jim Covello makes the case for variable  dividends that are contingent on business’s available cash flow.

According to Covello, 121 of the 700 dividend-paying companies in the Russell 1000 Index have suspended or eliminated payouts this year, especially in such sectors as energy, consumer discretionary and industrials.

Here are key takeaways from Covello’s comments:

  • “This is a concept that I’ve actually been talking about for a long time,” Covello said, noting that he wrote his first paper on the subject in 2013 while covering the cyclical semiconductor sector. He notes, “You shouldn’t have the same dividend strategy at all points in the cycle, because the cash-flow generation capability of a company is so different at different points in the cycle.”
  • Covello suggests a compromise in which companies can still pay a fixed dividend—“just make it very small and set it so that it is not going to strain your balance sheet and cash flow in a period of weakness. Then make the variable component of the dividend the much bigger component.”
  • On the notion of paying dividends in stock rather than cash (called “scrip” dividends), Covello said, “The challenge there is that if I’m issuing shares at a weaker part of the cycle, I’m giving away more of my company. With the variable-dividend proposal, we are trying to avoid [bad capital-allocation decisions].
  • Covello argues that a variable dividend removes the stigma of cutting a dividend because “the reason you’re so reluctant to do it is because of its signaling effect”—that it’s sending a message that a company is concerned about its cash flow. “There is no judgement that the company is making about what the forward-looking business looks like, which is what people worry about when they cut what had been a fixed dividend.”