Friday, January 9, 2009

Dividend Cuts - the worst nightmare for dividend investors

Some fellow investors argue that a dividend cut might not necessarily be a bad event, since management shows proactive steps in order to conserve cash until the company situation turns better. Furthermore, if many companies cut their dividend, which was the occasion during The Great Depression, I would be selling at low prices which would never again be seen for decades to come. Since markets could overshoot higher or lower on positive or negative news, selling right after the bad news of a dividend cut could be an example of buy high, sell low investment proposition. Last but not least, another argument is brought up, concerning the fact that stockholders should act as owners and be fine with a dividend cut, as it will conserve cash for the company and help it in its recovery.

While I realize that these are some valid concerns, I disagree with them for several reasons. First, if a company that has increased or maintained its dividend cuts or suspends its dividend, it shows that it doesn’t have a firm grasp of the current situation due to it being a cyclical company or because its business model is broken. Dividends are typically a sacred cow in US, and companies like to please shareholders with stable or increasing payments over time. The best dividend friendly companies out there make their business decisions with their shareholders in mind. They are careful with the capital allocation process so that their new ventures do not collapse causing the company to lose money and forego a dividend payment. Once management cuts or suspends its dividends, there is nothing that could stop them from cutting the dividend again or suspending the payments indefinitely. Furthermore, a company that shows fiscal irresponsibility to be unable to maintain its dividend payment is in great danger to even declare creditors protection.

Second, if most dividend stocks were to cut their payments due to severe unforeseen financial circumstances selling most cutters or eliminators might force investors to sell at what appear to be low prices, which go lower several months down the road, as more and more companies can’t afford paying out a dividend. Not all stocks will cut their dividend payments over time however, and this process will be spread out to several months if not years in the worst case scenario. Even during the great depression there were industries and companies which maintained a stable dividend payment. Companies like AT&T, Exxon and IBM are three such examples.

The markets do tend to overshoot based off news. My recent experience in 2008 has shown me that companies that cut or eliminated their dividends have not been good investments this year. Several of the stocks that reduced or eliminated their payments to shareholders provided warnings ahead of time for investors to get out while their stocks were still worth something.

For example Washington Mutual and Wachovia cut their dividend payment in April 2008, well before their stocks became worthless. General Motors suspended its dividend payment in July 2008 when the stock was trading at $10. Investors who sold when these negative news were announced, would have saved themselves from further losses. This underperformance of dividend cutters and eliminators is not just a 2008 phenomenon – according to Ned Davis Research, stocks with negative dividend actions have significantly underperformed the S&P 500 over the past four decades.

I don’t buy into the ownership idea in order to stop receiving income from my investments. If you owned a franchise and you asked the company to forgive you the franchise fees if they want you to stay in business, chances are your business will not last long, even if a temporary concession is done. In the corporations of the 21st century, the shareholder is the last one to get paid, as funds are typically allocated to projects that don’t end up generating enough cash to payoff for themselves, or on stock buybacks which increase the value of management stock options, but do nothing to improve the bottom line.

In conclusion, selling when a stock cuts its dividend is a wise decision meant to protect your capital and keep you in the game. It’s a risk management decision where you show that you were wrong in selecting the stock and that the factors that caused you to purchase it in the first place are no longer valid.

Relevant Articles:

- Best Dividends Stocks for the Long Run
- Dividends and The Great Depression
- Which Bank will be next? Follow the dividend cuts
- High yield stocks for current income

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