Wednesday, March 23, 2011

Avoid Dividend Cutters at All Costs

Companies cut dividends when they either expects that business would deteriorate to an extent where all cash might be needed to sustain the business or because they cannot afford to pay the dividend. When management expects losses that would drain cash in the near future, they are very likely to cut distributions. When dividends are cut, stock prices typically nosedive as the last investors who have held on hoping for better news leave the sinking ship. As a rule, I always sell when a company announces that it would be cutting dividends.

Over the past three years I have had four situations, where I have had to deal with dividend cutters and eliminators. In 2008 American Capital (ACAS) suspended its dividend payment. In 2009 General Electric (GE) and State Street (STT) also cut distributions, in the middle of the financial crisis. In 2010 oil giant British Petroleum (BP) suspended distributions, amidst pressure from the US Government to hold onto its cash in order to be able to pay for the oil spill it had created. In all but one of the situations, I would have been better off simply holding on, without selling.

The reason why I typically sell after a dividend cut is that as a group, companies that cut and eliminate dividends have underperformed the market since 1972 according to a study by Ned Davis Research.

Another reason why I sell is that with dividend cutters and eliminators you have the risk that the company might be on the brink of collapse. If your strategy was to buy companies after cutting dividends, you would probably realize a lot in gains when times are favorable, like in 2009. However, during severe bear markets, such as the one between 2007 and 2009 investors buying after a dividend cut might experience losses that could lead to total loss of principal. And once investors lose their capital, they are no longer in the game. If you had a 50% chance for an opportunity to make a 100% gain in one year, along with a 50% chance for an opportunity to lose 100% of your capital you should clearly stay away from this investment. The goal of successful dividend investing is not only generating a rising stream of income, but also ensuring that principal grows over time as well.

Investors who purchased General Electric (GE), State Street (STT) and BP after the cut were plain lucky. Investors who purchased Citigroup (C) , Bank of America (BAC) and American International Group (AIG) after the cut suffered severe losses. But those losses were nothing in comparison to investors who purchased Lehman Brothers, General Motors or Washington Mutual.

The moral of the story is that in order to be successful in investing, one needs to be able to find a strategy that offers some edge and some positive expectancy. It is also important to stick to that strategy and to only exit the position when a predetermined condition at the time of position initiation is triggered.

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