As an income investor, one of my priorities is to satisfy two simultaneous desires: the protection of current income as well as the organic growth of an income stream over time at a rate greater than inflation. To state the obvious, the implication is that I do not want a portfolio stuffed with companies that could cut their dividends after I spend years putting together a nice position in them. When I review the histories of the fallen dividend darlings, there are usually strong signals ahead of time that may warn you that a dividend company is falling apart.
Let's look at something like Eastman Kodak. The company basically spent 20+ years saying, "We're not a dividend growth company anymore!" From 1989 to 1993, Kodak froze its dividend. From 1994 through 1996, the company froze its dividend. From 1997 to 2000, Kodak froze its dividend. Yes, during the most prosperous decade in American history, Kodak was freezing its dividend. Then the company gave shareholders a hearty slash in 2003, cutting the dividend by about 40%. Then, the company cut the dividend again in 2004 by over 50%. This new low payout remained static until 2008. By the time the recession hit, the dividend was eliminated in entirety.
Kodak spent twenty three years telegraphing its deteriorating business model. On a relative basis, it did terrible in the 1990s. While the rest of corporate America was booming in the 1990s, Kodak was treading water. From 1997 to 2008, there were only two year-over-year periods when the dividend actually went up (2000 to 2001, and then 2001 to 2002). This is why dividends can be useful tools in evaluating the health of the company. Before Kodak's bankruptcy, the company spent over two decades effectively telling shareholders, "We no longer have the earnings quality to give shareholders dividend raises with regularity."
In some ways, a basic look at a company's business model can indicate that a meaningful dividend growth record should prove unsustainable over the long term. This is the case with Alcoa (NYSE:AA) and General Motors (NYSE:GM). Since 1982-1983, neither of these two companies has made it through a full business cycle in which they achieved returns on equity figures that outstripped capital expenditures by a great enough amount to create wealth. Alcoa's dividend freeze at $0.08 in the 1980s, and General Motors' dividend freeze at $0.50 in the 1990s served as the eventual reflection of this reality.
These faulty business models can be revealed by the weak dividend performance. Someone might look at a five-year chart of Alcoa and see that the company lowered its annual payment from $0.68 per share in 2008 to $0.26 in 2009 to $0.12 in 2010 (where it has remained since). But it did not have to take you until 2008-2009 to realize that Alcoa's dividend was in trouble.
From 2001 to 2006, Alcoa held its dividend steady at $0.60 per share. When the dividend stops growing for an extended period of time like that, it can often be a signal that portends further cuts to come. The static dividend during the first half of the decade was a hat tip of sorts to Alcoa shareholders that the long-term earnings power of the company was on thin ice.
Often enough, a company's dividend will cough and wheeze for an extended period of time before the company itself crumbles. A dividend freeze or cut is one of the best "canaries in the coalmine" that can indicate trouble for long-term investors in a particular company.
Dupont's (NYSE:DD) dividend had a rough go of it this decade, only growing by 1.5% annually over this ten-year frame of time. The dividend has only gone up by 2.0% annually over the past five years. Earnings have only gone up by 4.5% over that same period of time. However, it should not necessarily be surprising that 2004 to 2011 proved to be a period of weak dividend growth because the company held the dividend static at $1.40 per share from 2000 through 2004. It then held the dividend static at $1.64 from 2008 through 2011.
The company hasn't even given investors total returns of 5% annually since 2000 (despite only trading at 16-18x earnings then). The continual dividend freezes could have been a useful signal to shareholders that management anticipated tough times ahead in terms of growing the firm.
The fact that a company freezes or slashes its dividend is not an automatic signal of the company's health. If you bought Royal Dutch Shell (NYSE:RDS.B) after one of its dividend freezes in the early 1970s, you could have bought shares that have compounded at 12-13.5% annually since that time frame. If you bought General Electric (NYSE:GE) after its dividend cut during the financial crisis, you could have added some cheap shares to your household's balance sheet that may reward you with dividend raises for decades to come. It will always vary company by company.
But in the case of companies that do experience long-term earnings trouble, a dividend cut or freeze often precedes the difficulties to come (a notable exception would be collapsing financial companies). Kodak telegraphed its difficulties for over twenty years. General Motors and Alcoa froze dividend payouts before it became apparent that these two cyclical companies were having trouble adjusting their business models to new realities. And Dupont, which has continued to grow, has regularly frozen its dividend as part of a longer-term indication that the company has not yet recaptured its former glory. Blue-chip dividend growth stocks do not usually fall fast and hard. Sometimes, they even give you decades worth of indicators to realize that something is wrong.
Disclosure: I am long GE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.