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Portfolio Update

A Promising Start

By Roger S. Conrad, on Apr. 30, 2014

Healthy, growing businesses drive sustainable dividend increases and send stock prices higher.

Quarterly earnings season provides investors with the best opportunity to check whether the names in their portfolios are still on track.

Volatility always increases when companies report quarterly results; names that beat analysts’ consensus expectations often soar, while those that fall short take a plunge.

Of course, one quarter of good or bad results doesn’t make or break the year. Even high-quality companies suffer the occasional hiccup, while every dog can have its day during earnings season.

Here’s a review of the qualitative and quantitative metrics we use to evaluate the health of the Lifelong Income Portfolio’s holdings during these quarterly checkups. Considering these factors together provides useful insight into their future prospects.

No. 1: Dividend Sustainability

Many income-seeking investors consider the payout ratio (dividends as a percentage of profit) or coverage ratio (earnings dividend by the dividend) as the be all and end all of their quarterly due diligence.

The rationale behind this focus makes sense: No company can sustain its dividend indefinitely without sufficient cash flow.

But the payout ratio alone won’t provide insight into the sustainability of the company’s profits.

Boardwalk Pipeline Partners LP (NYSE: BWP), for example, last year generated enough distributable cash flow to cover its distribution but still slashed its payout by more than 80 percent.

In this case, the expiration of pipeline contracts–a risk that management highlighted during its quarterly earnings calls–forced the master limited partnership (MLP) to make this unpopular decision.

Investors should also consider trends in revenue and profit margins, as well as the potential drivers that could reduce or increase the company’s cash flow. You can also look at the company’s performance during previous downturns to gauge the reliability of its cash flow.

No. 2: Debt Burden

The amount of leverage a company can support varies widely between industries and business models.

A healthy utility that generates most of its cash flow from regulated operations can handle a debt-to-capital ratio of 45 percent to 55 percent, thanks to its highly visible future sales. However, we’d prefer to see less leverage in names that operate in cyclical industries where revenue is subject to greater volatility.

We tend to focus on the debt that a company will need to pay off or refinance over the next two years to gauge its near-term exposure to conditions in the credit market.

No. 3: Management’s Credibility

A company’s CEO is its top salesman–one of the reasons that management’s opening remarks during quarterly earnings calls are full of bluster and light on details.

Investors should keep close tabs on the reliability of management’s guidance and commentary. In other words, do the company’s results back up forward-looking statements made to investors?

When management teams do a good job setting expectations, their companies routinely meet or exceed guidance.

A name that regularly falls short of its internal forecasts or lowers its outlook considerably will experience greater volatility in its stock price and could be at a greater risk of cutting its dividend.

No. 4: Transformative Shifts

Investors should be on the lookout for major shifts in business conditions or a company’s strategy.

Reading a firm’s quarterly 10-k filings and listening to its earnings calls can provide a treasure trove of insight, but you should also check in with competitors and related firms to get a more complete grasp on industry trends and their implications.

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