Why It's Wise to Sell on Dividend Cuts

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 (T), Exxon (XOM) 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 (WM) and Wachovia (WB) cut their dividend payment in April 2008, well before their stocks became worthless. General Motorsd (GM) 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.

Comments

[Paul Price:]

Even better than selling after a dividend cut would be realizing the payout was likely unsustainable and selling BEFORE the big drop that accompanies the dividend reduction announcement.

Jan 11 01:00 PM

[User 283977:]

Yes, for dividend investors, the dividend is part of the rational for owning the stock in the first place. If the dividend is cut, it usually signals significant problems and I think it would be prudent for investors to sell at that point.

As Paul points out being able to predict a future dividend cut is even better since you get out before the drop. But how do you do that?

One way is to do a deep dive into the companies financials. However, I have a simpler way that often works. Because companies don't like to cut their dividends, the dividend amount often stays the same as the stock drops on business difficulties. So one red flag with respect to a potential cut in the dividend would be to see the size of the percent dividend yield substantially increase. If a dividend for a normal equity is above 7%, that COULD be a red flag that requires a closer look. It does not mean to sell, it just means take the time to look at the historical dividend yield for the stock.

A good example is BAC. Bank of America had an 8.5% dividend when its stock price was at $30. The reason the dividend yield got so large was because of the large decrease in their stocks price. This is what is often referred to as an "accidental high" dividend. When you see this, its a red flag that suggests you look back at the stocks historical percent dividend yield. For BAC, the historical percent dividend yield when the stock was at $50 was around 5%.

If the current dividend yield is substantially higher than its historical yield, and the stock price has recently decreased, the probability is higher that the stock will decrease its dividend, and consequently, its a sell signal.

Note that the current stock price for BAC is $15, and once again the percent dividend yield has increased up to 8.5%. There has also been some financial news that BAC is going to need more capital in the near future. You can maintain your capital position by cutting the dividend. So once again, the signal here is a higher than normal dividend yield accompanied with a stock price decrease. So for the dividend investor, the signal says sell.

What is your way of determining if a stocks dividend is going to be cut?

Jan 11 04:02 PM

[Urbane Gori...:]

RE: "The markets do tend to overshoot based off news. .........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."

I've been warning about this for quite awhile. My advice is if the dividend is too high, or if the company is in an adverse sector, it's time to start selling as the stock tops. There is no sense in waiting for the dividend to drop before selling; that's selling at the bottom.

You want dividend stocks, look for companies that do not need to borrow, have good cash flows, are in a protected sector and preferably have not only already cut their dividend, but also suffered a loss in stock value as a result. As other companies cut and lose value, your new stock will have been forming a base and possibly turn up.

Watch REITS, shipping and energy...... jegan ;-)

Jan 11 04:46 PM

[Financial A...:]

Exactly what I was thinking when I read the title.


On Jan 11 01:00 PM Paul Price wrote:

> Even better than selling after a dividend cut would be realizing
> the payout was likely unsustainable and selling BEFORE the big drop
> that accompanies the dividend reduction announcement.

Jan 11 07:53 PM

[Financial A...:]

@Bob Lunn,

"What is your way of determining if a stocks dividend is going to be cut?"

I'd check out the payout ratio. The logic is very similar, in that if the payout ratio increased by a significant amount, like say, from 20% of earnings to 85%, or even over 100%, then you have a key indicator of an unsustainable dividend. Such numbers are published in the S&P STARS reports that are generally free for anyone with a brokerage account.

Jan 11 07:57 PM

[User 283977:]

Excellent idea Financial Acumen!

Jan 12 11:01 AM

[tk77mann:]

Yahoo Finance also publishes the dividend Payout Ratio in the Key Statistics page for every stock.

Besides the Payout Ratio, I look at the Free Cash Flow versus the total Dividends paid out every quarter. On the Yahoo Finance Cash Flow page for every stock you can see where a company's cash went to per quarter and per year. If Net Income plus Depreciation is significantly higher than Capital Expenditures plus Dividends Paid, then there is more assurance the dividend is fairly secure. (No guarantees, though, especially in this business climate.)

On the Cash Flow pages you can also see if the company has been buying back stock or selling more, and/or issuing more debt or paying it off. A number of companies are issuing more stock and/or more debt to have the cash to pay their generous dividends. Unless their business and profits increase they will have to eventually cut their dividend.

The companies I really like are the ones that increase their dividends AND buy back stock AND pay down debt regularly. Safest stocks around for my money.

Jan 12 11:43 AM