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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  1. I guess I'm just plain lucky, or maybe, just saw something temporary that created a huge buying opportunity.

  2. Are you planning to switch from Zecco to another brokerage since Zecco is getting rid of free trades? If so, which brokerage?

  3. What can I say, another fabulous DGI article. Spot on sir. Thank you for publishing.

  4. DGI, you commented that in three of the four cases where you sold dividend cutters, you would have been better off holding on (and waiting for a recovery). But, you also provide examples of companies where selling after a cut would have absolutely been the best choice to avoid a big capital loss.

    I think dividend cuts force a careful re-evaluation of a stock, but shouldn't be an automatic sale trigger. You need to consider the reasons for the cut.

    Most of the financials cut in '08-09 for self-preservation. If cutting the dividend is the last ditch (and late) effort to try and save itself, then run away from the company. The risk of losing all your capital may be significant.

    BP suspended its dividend for political/PR reasons, maybe more than for self-preservation. Was BP really likely to become worthless? Its stock price had already been punished by the time it cancelled its scheduled dividend. The risk of holding on may have been more tolerable. (I personally sold and took a loss.)

    On the other hand, Pfizer cut its dividend to fund growth (by acquisition). A (PFE) investor might have found this quite tolerable, instead of using debt or issuing shares.

  5. Thanks everyone for postiing.

    I am looking for another brokerage that charges $0 for trades but also doesn't charge monthly maintenance fees.

    I have an account with SogoTrade, where they charge $3 trades. If you are a new account holder they would give you 100 free trades for 30 days. If you want to help a brother out, send me your e-mail and I will send you a referal so I could also get free trades :- )

    dividendgrowthinvestor at gmail dot com.

    Last anonymous,

    Selling dividend stocks after a cut is more of an art than science. People who bought BP, STT or GE after the cut made very high return. The people who bought after WaMu, Citigroup, Bank of America or Lehman cut dividends lost a LOT of money. So on average this strategy would not pay off. If you make 1000% on an investment, but then you lose 90% on the next investment you are left with the same amount at the end of the day :-)

  6. DGI,

    I agree with the principle of what you were saying. I personally bought into BP shortly before the dividend was cut, but I did not buy it because of the dividend in this case. I saw the company, looked over the financials and decided that it was well worth the risk. I just could not see the company going out of business, they made too much money.

    Anyways, I do enjoy your blog keep them coming.



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