The Dividend Cut And Run - Or Should You Stay?

Includes: VYM
by: Dale Roberts

Investing is a piece of cake when things are going well. A rising tide can lift all boats as the saying goes. The time when investors earn their keep and make their money is when "things" go bad. As in 2008-2009, 2000-2001, 1966-1980, etc. Instead of a period when investors make their money, I should add it's more of a time when too many investors lose their money.

It will likely be no different for dividend growth investors in the next correction. Dividend growth is a great strategy that can allow investors to focus on dividends and dividend growth. And as I acknowledged in this article, executed correctly, a dividend growth strategy can certainly lead to a market outperform. But it's a strategy that certainly carries a great deal of risk or volatility. Dividend growth of course means holding equities - it's an equity strategy. It's certainly less risky than holding sector or developing nation stocks or funds, but the stocks carry the risks of the market. And certainly a dividend growth stock portfolio is one notch lower on the risk scale than the broader market.

In the next correction, dividend growth investors will be hit on a couple of different fronts. First of course there's the portfolio value hit. Portfolio values can certainly fall 50% in a severe correction. That's hard to take for most investors, and certainly for those who are new to investing, or are new to investing in a strategy that is stock-heavy.

And dividend growth investors will also be hit on the dividend front. As I stated in this article, in the last correction (The Great Recession) 37% of dividend champions froze, reduced or eliminated their dividend payments. Dividend champions are companies that have increased their dividends every year for 25 years or more.

Navigating through dividend upheaval is not an easy task, especially when it's your first time through a major correction. Knowing when to remove a dividend stock from your portfolio due to a dividend cut, freeze or reduction is a tricky task to say the least. And once you remove a company from your portfolio and sell into a recent price decline (or loss) you are reducing the funds available to purchase future income.

In 2009, for investors who held (NYSE:GE) and then sold on GE's dividend cut, it was too late. By the time GE cut its dividend in February of 2009 GE's stock price had already fallen by about 80% from its recent peak (of the period). Investors had 80% less cash available for their next purchase. They may be rotating into a new and more favourable company (or reinvesting that redemption into existing holdings) but it may take several years to make up that loss.

Head back to 2008 on Seeking Alpha and you'll see a notable dividend growth author or two recommending GE as a great long-term dividend investment. David Van Knapp recommended GE in August of 2008, at a price of $28. Mr. Van Knapp stated ...

In addition to its characteristics as a growth stock, GE is a reliable dividend stock. It has paid dividends since 1899 and increased them at more than 8% annually for 50 years.

Yet in June of 2009 GE cut its dividend from .31 to .10. it's certainly hard to read the tea leaves. GE had a share price of $24.60 in August of 2008, it fell to $11.95 in June of 2009. An investor who practiced the dividend cut and run would have suffered a 50% plus loss, and would have 50% less to reinvest in the next dividend company. Mr. Van Knapp may turn out to be right, it depends on your definition of long-term.

Many dividend growth investors will offer that waiting for a dividend cut to part ways is not a suitable strategy. This article by The Part-Time Investor looked at such a strategy and how it would have performed through the recession. He used his own selection criteria and created a portfolio of dividend champions. When a company cut its dividend, he sold it and replaced it with a company that met his selection criteria.

The portfolio did very well moving out of the recession on a total return basis. But the portfolio's income fell heavily through the recession and the dividend income did not recover coming out of the recession and during the current recovery. In fact, the portfolio's income would have lost real spending power from 2008 due to inflation. Many will cite protection from inflation as a benefit of dividend growth and the main objective for many. But this strategy over this period performed poorly. Cash would have outperformed this strategy on the income front.

And most experienced dividend growth investors will advise that waiting for a dividend cut is not a useful approach. By then it's too late. But what is the best approach? Selling on a dividend freeze? Selling the first sniff of management's intention to not maintain a record of dividend growth. And to complicate things further SA author Jeff Paul did a series of articles that show that buying on a dividend cut can actually produce some positive returns. Here was Jeff's finding on dividend champions (non financials) that had reduced their dividend from 1999-2006.

As a group, the average total return through 2007 was an 89% gain since the cut announcement date, and 137% through 2010. This translates into approximate annualized gains of 11% and 10%, respectively. This handily beat the respective S&P returns of 41% (6% annualized) and 29% (3% annualized) for the same time periods.

In many cases, holding on even through dividend cuts and buying on cuts can be beneficial.

Perhaps in the case of GE, Jeff Paul's thesis holds true, the time to buy GE would have been on the dividend cut. It has raised its dividend from .10 to .19 from June of 2009.

And of course, some dividend growth investors will advise that you look at earnings - the canary in the dividend threat coal mine. But that's certainly tricky business as McDonald's (NYSE:MCD) demonstrates. Those investors who stuck by McDonald's during the lean years have been rewarded, handsomely. Over the last 15 years McDonald's has delivered with an ever increasing income stream, and has offered a total return of some 450% over that period. But it has not been a smooth ride on the earnings front and their have been some missteps along the way.

Here's a headline from Fortune Magazine in 2002 …

Fallen Arches McDonald's has had six straight earnings disappointments. Its stock is down 42%. And we can't even remember the jingle! What happened?

Wow, sounding the death knell for McDonald's. That seems like a spectacular overstatement in hindsight, but those are the headlines an investor would have been reading back in 2002. Even Warren Buffett sold his stake in MCD. He later admitted that was a mistake. SA writer David Crossetti held on to McDonald's through thick and thin, and has the returns to prove it. Mr. Crossetti demonstrated more patience and correct instincts than the greatest investor on earth. Good on ya. Chalk up another one for patience.

A better option for investors who are new to the game or are not comfortable with their ability to manage a portfolio of companies through a recovery is ETFs. As I demonstrated in a series of articles, investors can certainly create a dividend growth ETF portfolio that meets the parameters of dividend growth and generous yield. And a major benefit of an ETF dividend growth portfolio during a correction is that there is nothing to manage. You cannot manage it, other than (hopefully) staying the course and reinvesting the dividends. An investor does not have to decide when to cut and run, that is decided by the ETF's predetermined criteria for inclusion in the dividend growth fund. An investor does not have to decide where to invest new funds and dividends.

So how would an ETF perform during a correction? Let's take a look at the core dividend growth ETF that I used in my multiple ETF dividend growth portfolio - Vanguard's (NYSEARCA:VYM).

Here's how a starting portfolio value of $100,000 would have fared during the great recession. Dividends are reinvested as available into the fund. I would think (guess) that many dividend growth investors would have experienced similar declines and patterns in their self-directed portfolios, and I certainly invite them to post their results in the comment section. Unfortunately it's a small list of SA dividend growth authors who actually invested through the last correction or two - or at least invested through those corrections and reported their results on SA.

Date Unit Price Dividends Reinvested div Units Held Portfolio Value
Start Nov 06 1979 $100,000
December 06 51.64 .18 $356 1986 102,552
March 07 51.56 .27 $536 1996 102,934
June 07 53.92 .30 $598 2007 108,222
September 07 54.65 .35 $702 2020 110,393
December 07 51.91 .45 $909 2037 105,767
March 08 46.83 .37 $754 2053 $96,141
June 08 42.79 .37 $760 2070 $88,605
September 08 41.00 .37 $765 2088 $85,636
December 08 32.31 .33 $689 2109 $68,141
March 09 28.50 .31 $653 2132 $60,762
June 09 31.40 .00 $0 2132 $66,944
September 09 36.32 .26 $554 2147 $77,979
December 09 38.38 .32 $687 2165 $83,093
March 10 39.45 .23 $498 2177 $85,882
June 10 36.46 .27 $588 2193 $79,957
September 10 39.19 .28 $614 2209 $86,570
December 10 42.23 .31 $685 2225 $93,961
March 11 39.45 .31 $690 2242 $88,446
June 11 43.52 .34 $762 2260 $98,355
September 11 39.94 .31 $700 2277 $90,943
December 11 44.94 .38 $865 2296 $103,182
March 12 48.60 .33 $758 2311 $112,314
June 12 46.48 .37 $855 2329 $108,251
September 12 50.81 .40 $931 2347 $119,251
December 12 50.07 .49 $1150 2370 $118,665
March 13 54.39 .36 $853 2385 $129,720
Total May 56.87 $135,634

As we can see from the portfolio value the investment took a hit, dropping some 50% into early 2009. And investors would been underwater in total portfolio value for 15 quarters. That's almost four years of course. As with all equity investments patience and fortitude would have been required. The portfolio then recovered and went on to deliver a 35% total return to May of 2013. That's slightly above the S&P 500 return for the period, but below the Dow 30 (NYSEARCA:DIA) - that has been a more solid performer in the short term.

On the more important income front, VYM greatly outperforms Part-Time Investor's model. If we take the four dividend payments from VYM for 2007 we have an average of $686. The last four dividend payments from VYM offer an average of $947. We have an income increase of 30% moving through the recession.

Dividend growth investors who select their own companies may or may not have beat those results on total return and income criteria. It would have come down to company selection criteria and more importantly - crisis management.

I think most investors would be very interested in hearing from the dividend growth investors who navigated through the great recession. When did you cut and run? How did you succeed, where did you go wrong? Hey, even Warren Buffet has trouble with this stuff upon occasion.

How will you prepare for the next correction? The big one gets closer every day.

Disclosure: I am long DIA, VYM, EFA, EWC. 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. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. Streetwise Portfolios offer Canadians low-fee, complete, index-based portfolio options. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.