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If you are an income investor with common stocks, the biggest risk to your strategy occurs when a company cuts its dividend. Some investors, particularly proponents of "modern portfolio theory", may argue that the threat of extreme volatility is the greatest risk to investors. I disagree with that notion because volatility, particularly in the form of falling stock prices, can be your best friend as long as the long-term earnings power of your company remains intact (just run some figures on how much quicker your income grows when you're reinvesting your dividends into Exxon (XOM) at $60 or Chevron (CVX) at $65).

For the most part, dividend cuts are the big risks that income investors have to address. When a company cuts its dividend, it is almost always an indication that the long-term earnings power of the company has been compromised (I say "almost always" to account for fluke events that involve things like United States government entities forcing Wells Fargo (WFC) to cut its dividend during the financial crisis, even though it did have the ability to continue with its dividend payouts).

The dividend payout, whether it is a raise, freeze, or cut, can tell you a lot about the overall health of the company. Pepsi (PEP) raised its dividend by 6% yesterday. Well, Pepsi has been growing by 5.5% these past five years. Even if it lags a bit, the dividend is usually a reflection of the company's earnings growth. You can learn a lot about how a company is doing by monitoring how much cash it is willing to relinquish to shareholders.

Today, I want to discuss with you how I approach reacting to events when a company cuts its dividend.

First off, I should acknowledge that some intelligent income investors keep it simple: they sell as soon as a company cuts or freezes its dividend. Their goal is to own companies that grant shareholders automatic increases in income each year, and when a company stops meeting that objective, they sell. The advantage of this approach is that you will always own assets that are churning out more and more dividends for investors each year. It is useful knowing that every stock in your portfolio is working towards your end goal.

However, I do not follow the automatic sell rule, and here is why:

1. The price to switch to another dividend growth security can be steep. Everyone in the marketplace knows that a dividend cut is a bad sign because it reveals a deterioration in corporate health. By the time a company gets around to cutting its dividend, the share price has usually fallen significantly (if the share price has not fallen, it could make a lot of sense to get out). In many ways, selling at the moment of a dividend cut seems like a perfect set up for "selling low". That's why I like to use the moment of a dividend cut as a moment of reassessment to determine whether the company's long-term earnings power is still satisfactory.

2. Some companies experience dividend cuts on a somewhat regular basis, even if they are excellent dividend investments. The best example of this is Royal Dutch Shell (RDS.B). If you trace Shell's corporate history all the way back to its predecessor firms in the early 1910s/1920s, you will see that the company has returned 14% annually over that time frame. Even more impressively, 70% of those total returns can be attributed to the company's historically generous dividend payout. But interestingly enough, Shell does not hesitate to cut its dividend when oil prices are low. Since 2005, the company has cut its dividend once and frozen it from 2009-2011. This can be particularly frustrating because the company cuts its dividend when share prices are low, and this is precisely the moment that it is the best time to reinvest. But still, I would not want to automatically sell a company like Shell just because it cuts or freezes its dividend, because often enough high total returns and high dividends have been around the corner for patient investors.

That's why I like to treat a dividend cut or freeze as a time to reassess. The power to think independently is the greatest gift we investors have, and I don't want to outsource my personal judgment to an automatic sell rule, because each situation that involves a dividend cut or freeze is highly fact specific about the company involved. For every Wachovia, there is a General Electric (GE). For every Eastman Kodak, there is a Wells Fargo.

Here's my approach for dealing with a dividend cut: Ask yourself, has the long-term earnings power of the company been compromised in a meaningful way?

If the answer is no, I'm going to sit tight.

If the answer is yes, and I do not like the odds of a restoration to profitability within five or so years, I'm getting out of the stock. I'm taking my losses and moving on. I made an error in judgment, and I have to suffer the consequences. Generally, this reinforces my desire to be diversified so a few bad judgment calls won't prevent me from reaching my goals. If someone as smart as Charlie Munger can lose money with real estate projects in Santa Barbara, then I'm certainly capable of making mistakes. The key is to structure your assets in such a way that the setbacks can easily be overcome.

Not all dividend cuts are equal. Oil companies can be great dividend investments, but companies like Shell, BP (BP), Total (TOT), and Conoco Phillips (COP) won't be showing up on any "this company has been growing dividends for 50+ years" lists anytime soon. You should know that going into the investment. Incidentally, dividend cuts or freezes at BP and Conoco have been excellent times to initiate positions. Imagine establishing long-term positions in BP at $27 after the oil spill, or buying Conoco in the upper teens during its dividend freeze years of 1998-2000 (and plus, you would get the benefit of the Phillips 66 (PSX) spinoff down the road).

If annual dividend growth with an oil company is important to you, I'd stick with Chevron and Exxon . They are getting to the point where they are so diversified that they can absorb just about any realistic worst case scenarios with oil prices and still grow the dividend.

Dividend cuts in the oil sector are somewhat normal when you talk in terms of 10+ year periods, and in many cases, represent a good time to establish a position in a company.

However, I would be very alarmed if a retail, fast food, or tech company cut its dividend. Usually, those dividend cuts can be a signal that the company is falling apart. I own both McDonalds (MCD) and IBM (IBM) stock. If either of those companies posted very poor earnings results (say, earnings per share declines of 40% or more), I can think of almost no circumstance in which I'd stick with the stock. That's all based on the theory that history repeats itself.

The fast food industry is notoriously competitive. McDonalds has been just about the only long-term winner in the sector. If it started to falter and had to cuts dividend, I wouldn't stick around for its rehabilitation.

Likewise, tech companies like IBM have incredibly low payout ratios. They have tons of free cash flow that they can use to address obstacles on the horizon. If IBM management ever felt that it needed to conserve cash that only represents about 20% of current cash flow, I'd be very alarmed by what was about to come, and I'd get out.

By the way, I want to end this article on an optimistic note. Remember that the most important thing to do is structure your assets in such a way that it does not matter how you answer the "What would you do when your company cuts its dividend?" question. Picture this.

Let's say you had $10,000 worth of annual dividends that came from the usual suspects like Coca-Cola (KO), Colgate-Palmolive (CL), and Johnson & Johnson (JNJ). Another $1,000 came from bank stocks like Bank of America (BAC), Wells Fargo , JP Morgan (JPM), and Goldman Sachs (GS) before the financial crisis. Even if the $1,000 worth of bank dividends cut its payouts by 80%, you would still be generating $11,000 worth of annual dividends as long as the $10,000 pool had a dividend growth rate of 8% or above. Intelligent diversification can allow you to tolerate dividend cuts without missing a beat.

Source: What To Do When Your Stock Cuts Its Dividend