The Peter Lynch Approach To Dividend Cuts

 |  Includes: AJG, GIS, HSY, LO, PBI, PG, XOM, YORW
by: Tim McAleenan Jr.

In his follow-up after "One Up On Wall Street", Peter Lynch wrote "Beating The Street" that provided many tidbits about how he broke down the step by step process of stock selection. In Chapter 7 titled "Art, Science, and Legwork", Lynch provided some insight into how he thinks about dividend cuts:

I rejected Green Acres because of a passing reference in its latest quarterly report. I've always found it useful to pay attention to the text in these little brochures. What caught my eye was that this company, which owns a Long Island shopping center, was debating whether or not to pay the regular quarterly increase (of one cent) in the dividend as was customary. Green Acres had raised its dividend every quarter since it went public six years earlier, so to break the string to save $100,000 I took as evidence of short-term desperation. When a company that has a tradition of raising the dividend mentions in public that it might discontinue the practice for the sake of a paltry savings, it's a warning that ought to be heeded. In July 1992, Green Acres not only didn't raise the dividend, it cut it drastically.

As an aside, this is why I spend most of my time looking at companies that have been raising their dividends for two, three, four, or even five decades. These companies don't have debates about whether or not to pay out a dividend. It's understood. Exxon (NYSE:XOM), General Mills (NYSE:GIS), and Procter & Gamble (NYSE:PG) have been paying dividends without interruption for over a century. WWI. WWI. Korean War. Vietnam. Cold War. 9/11.

Name the disaster, and these companies were paying out a dividend during it. Heck, they are only a generation away from being able to say that they paid out dividends during the Civil War (incidentally, Lorillard (NYSE:LO) and York Water (NASDAQ:YORW) both did just that. You could have been collecting your water and tobacco dividends as the Confederates marched into town). If I buy something like General Mills, I don't have to worry about the Board of Directors musing out loud about whether they are going to pay the same dividend next quarter.

In Lynch's case, I appreciated this advice in particular: when a company that has a tradition of raising the dividend mentions in public that it might discontinue the practice for the sake of a paltry savings, it's a warning that ought to be heeded. In my personal decision-making, I try to take Lynch's thought process and combine it with the following: the context of the broader economy.

Take something like Kodak. The company froze its dividend in the early 1990s. It froze its dividend in the late 1990s. That's a bad sign for large-cap stock in and of itself. But during a period of time when the rest of corporate America was thriving, Kodak was only able to remain steady. That's especially worrisome.

The timing of a dividend freeze means something. Although there are some exceptions, I would generally be much more alarmed by a company that cut its dividend in 2012 or 2013 compared to 2008 or 2009. Plenty of quality companies had to retain capital in 2008/2009 and made a decision to temporarily conserve capital by freezing the dividend (think Hershey Chocolate (NYSE:HSY) or Arthur Gallagher (NYSE:AJG)).

All else equal, I'm more skeptical about the long-term earnings power of a company that cuts its dividend during relatively normal economic times compared to something like the 2008-2009 time period (and for companies that were able to increase their dividend payouts during this period of time, it makes their long-term record all the more impressive).

What I particularly like about Peter Lynch's approach is that dividend decisions can reveal a lot about a company's management. For the most part, most management projections will tell you that the company is expecting things to be better 3-5 years from now than they are today. That could very well be true. But observing the dividend growth rate can be a useful way to cut through the BS. If a company is predicting high earnings per share growth in the future, and had a strong dividend growth rate over the past decade, I would be suspicious if the dividend only grew by 1-3% annually. The slower increases could reflect a lack of confidence about future corporate earnings growth.

Pitney Bowes (NYSE:PBI) is a real life example that can demonstrate this mismatch. If you go back and read the statements from management between 2003 and 2010, you will almost always see some variation of "We have near term challenges, but expect stronger growth over the long term." Well, the long term never came. Before the recent dividend cut, Pitney Bowes had a 2.5% dividend growth rate from 2003-2012. Since 2000, the company had only once increased the total dividend payout by more than a nickel. The sluggish dividend growth reflected the long-term hardships facing the company that eventually manifested themselves in a dividend cut last month.

Lynch avoided Green Acres because he recognized that the dividend freeze signaled bad things to come. If a management team has the high conviction that earnings will be growing by a satisfactory amount in the short-to-medium term, then the company should be able to back that conviction up by raising the dividend. If a management team with a record of raising dividends decides to freeze the dividend (and they cannot give a satisfactory reason why), then it raises an important question: when a management team can't raise the dividend, what does that say about how they truly feel about earnings three to five years down the road?

Disclosure: I am long XOM, PG. 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.