By Robert Ross
Even the best investors have bad days.
Warren Buffett is no exception. In February, he watched one of his biggest acquisitions quickly sour.
I’m talking about Kraft Heinz, an American food giant that makes everything from ketchup to Oscar Mayer hot dogs to Kool-Aid.
The stock plunged 30% in one day after it announced a 36% dividend cut and never recovered:
This caught a lot of investors by surprise. That’s because Kraft Heinz fit Buffett’s signature strategy, known as value investing, to a T.
Buffett has used this strategy to make billions of dollars. So people expected Kraft Heinz to be safe.
But the writing was on the wall well before February. Here, I’ll explain why—and how to avoid stocks with similar problems.
But first, let’s look at how Buffett got into this jam…
There’s Always Money for a Coke
Value investors like Buffett make money buying stocks that are trading for less than their intrinsic value.
Imagine, for example, that a stock is trading for $20 per share. But your research says it’s worth $25 per share. If you’re correct, and the share price rises, you make a profit.
That’s how value investing works in a nutshell.
This strategy is one of the reasons Buffett acquired an 27% stake in Kraft Heinz in 2015. It also matched his preference for easy-to-understand companies like Coca-Cola and Duracell.
In theory, people buy their products no matter what’s happening in the economy. There’s always money for a Coke, a pack of batteries, or a hot dog, even when you’re broke.
No One Drinks Kool-Aid Anymore
On the surface, Kraft Heinz looked like a stable company with a safe dividend. Finding such companies is my forte, so check out my latest special report where I reveal my favorite dividend stocks for 2019. But if you looked deeper, you’d see the company is actually dealing with many issues.
The biggest issue is that Kraft Heinz doesn’t keep up with changing consumer trends.
People don’t want prepackaged foods like Oscar Mayer hot dogs anymore. Instead, they want simpler, healthier foods with fewer processed ingredients.
This has weakened demand for the company’s core products. (When was the last time you saw someone drinking Kool-Aid?)
In fact, the company’s sales flatlined from 2015 to 2018. Earnings rose slightly, but this came from cutting costs, not growing sales. Still, Kraft Heinz kept raising its dividend.
This was a major red flag.
How to Spot an At-Risk Dividend
When a company’s dividend rises faster than its earnings, it increases a closely watched indicator called the payout ratio.
The payout ratio is the percentage of net income a company pays to shareholders as dividends. The lower the payout ratio, the safer the dividend payment.
In Kraft Heinz’s case, the payout ratio has been rising for three years. Over that period, it has averaged 94%. That means the company immediately paid out almost every dollar it made.
Again, this is a major red flag. If a company pays out all of its profits in dividends, there’s nothing left over to reinvest in the business.
With Kraft Heinz, sales were already struggling. Add in the rising payout ratio, and more investors should have been wary.
Instead, they were hypnotized by Buffett’s blessing and the company’s (former) 5.5% dividend yield.
Then the inevitable payday came. February’s big dividend cut sent shares down 30% in one day. This cost Buffett’s Berkshire Hathaway a paper loss of over $4.3 billion.