Retired Income Investors - What You Need To Know About Dividend Cuts

Includes: DX, FUN
by: Bob Wells

Look at just a few of the highlights of a 2012 study by Eagle Asset Management:

  • S&P 500 Dividend Aristocrats beat the S&P 500 Index over the last 1,3,5,10,15, and 20-year periods as of March 31st, 2012, with lower volatility as measured by standard deviation.
  • From 1980 to 2005, S&P 500 dividend payers outperformed non-payers by more than 2.6 percentage points each year.
  • Dividend payers outperform non-payers in a range of different interest rates environments.

Since I'm retired and drawing retirement income from my investments, I find such research reassuring. I suspect that since you clicked on this article you too are investing in stocks that pay a dividend or considering such a move. Hopefully by now most of you know that all dividend stocks are not created equal. Many come with irregular distributions while others are just plain risky. Dividend stocks are great for those of us in retirement because they help provide necessary income. Even better are those dividend stocks with a track record of consistently growing their dividends at a rate greater than the rate of inflation. I have my equity positions invested exclusively in Dividend Growth stocks yielding 2.7% and above. Roughly 90% of my stocks are Dividend Champions, Contenders and Challengers or what are commonly called the CCCs. The stocks have the distinction of not only paying but growing their dividends for 5 or more straight years. The remainder are "Near Challengers" or "Frozen Angels". My current portfolio is available here.

It is important for those of you that are retired or are soon to be, to take the time to fully explore this important resource. When you do, you will find important information on not only over 460 Dividend Champions, Contenders and Challengers but a list of Near Challengers, those stocks with four years or more of dividend growth and a list of "Frozen Angels", dividend stocks that froze their dividend and have temporarily suspended dividend growth. Lists of the stocks making up the CCCs including important monthly updates are maintained by SA Contributor David Fish and are available here.

Dividend Growth portfolios do more than provide consistent dividend distributions and dividend growth greater than the rate of inflation. Most retired investors have chosen this model, like owning a portfolio that doesn't directly depend on growth of capital to supply their retirement income. Most also appreciate that they don't have to sell shares to obtain 4% plus retirement income, a fact which proves particularly important during sustained down markets.

For the retired Dividend Growth investor, there is one major concern, loss of income due to a cut in the dividend. When I visit the Seeking Alpha website, I routinely click on the Market Currents tab, after which I click on Dividends. Here I can quickly learn which stocks increased their dividend payments and which have cut their payments.

Those of you already familiar with my writings know my law enforcement background makes me a fan of closely examining history. At the end of my first year as a self-directed income investor, I did a comprehensive back test in search of the most consistent, least volatile dividend growth stocks during the turbulent 10 year period between 2002 and 2011. The latest update of these "Dividend Safety Superstars" begins here. I'll be adding to those companies qualifying soon so be sure to stay tuned.

This time around, I thought it was important to take a closer look at how the issue of dividend cuts has played out historically. Between the years 1999-2010, 56 firms cut their dividend. Of that number 22 financial firms cut. Consumer discretionary holdings were second with 13. Industrials were third with 6. Particularly revealing is the fact that 68% of these firms had a 4 week or longer period where they underperformed the S&P 500 by more than 20%.

According to information maintained by David Fish between 2008 and today, 72 companies have cut their dividend with the average for this shorter period being 12 per year. 28 companies cut during 2009, a reflection of the Great Recession and an additional 18 companies cut in 2012. During this period less than 10 cuts per year represented the norm. 2010 was clearly the strongest year for Dividend Growth stocks with only a single company cutting its dividend.

Let's break down the cuts during this period even further. Of the 72 companies cutting their dividend between 2008 and today, 26 were banks. What I found even more disturbing was that 10 of these banks cut their dividend a second time. An additional 13 cuts came from the financial sector, meaning that over 50% of the dividend cuts came from this sector. Of these financials, 8 were REITs, including one mREIT, Dynex (NYSE:DX), which in so doing lost its distinction of being the only mREIT among the CCCs. When you look further, you find that the REITs that cut were by and large what are called specialty REITs. Cedar Fair (NYSE:FUN) is just one example.

Another revealing finding was that 14 foreign companies cut during this period, no doubt due to weakness in the European economies. Not surprisingly the greatest number of dividend cuts occurred in the ranks of Dividend Challengers - those stocks that have consistently raised their dividends between 5 and 9 years. 19 Challengers cut their dividend during this period. The third highest percentage of cuts came within the ranks of what could be called "Early Contenders"; those having consistently grown their dividends between 10 and 14 years, with this group experiencing 10 cuts. Surprisingly, the second largest concentration of cuts came within a group of Dividend Champions with between 35 and 39 years of consistent dividend growth. Most were financials and industrials.

Just as important as determining which stocks have the strongest histories of cuts is to locate those sectors where historically cuts were least likely to happen. When you review the list, what you won't find are U.S. Consumer Staples or Utilities. You won't find healthcare REITS or triple net REITs with wide geographic coverage among the dividend cutters. You also won't find Master Limited Partnerships or MLPs.

Now it's your turn. What's your takeaway from this brief look at the history of dividend cuts?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.