A Contrarian Strategy For Quick Capital Gains

It goes against common sense to buy stocks when they cut their dividends, but this is a contrarian strategy which can lead to quick capital gains. Analysis is required to determine that the dividend cut is part of a corporate resctructuring plan which will work, i.e., actually reduce costs and increase future profitability. Timing for trade entry is crucial. Here are some recent examples.

On March 16, 2006, Con Agra Foods (CAG) reduced the dividend from .2725 to .18 per share as part of a plan to improve profitability. This disappointed many investors, since CAG had been one of the “dividend aristocrats” and they had increased their dividend annually for many years. There was an immediate and sharp selloff which bottomed at 18.42, but then the stock rose strongly and ended the year at 27.00 for a gain of 46%.

CAG 1-yr chart

On February 7, 2006, General Motors (GM) reduced the dividend from 2.00 to 1.00 per share as part of a broad cost-cutting plan. The move had been widely anticipated, but the stock still stumbled for weeks before making a low in April at 18.53. GM ended 2006 at 30.72 for a gain of 65%.

GM 1-yr chart

On September 25, 2006, in the aftermath of the tainted spinach disaster, Chiquita Brands (CQB) suspended dividend payments and said it would consider selling its shipping business in an effort to cut debt. The stock plunged and made a low at 12.52 in early October, then rallied; CQB ended the year at 15.97, a gain of 28% in less than three months.

CQB 1-yr chart

Comments

[Quaker:]

IMO, the dividend cut argument is even stronger with Gas royalty trusts. One reason is the type of investor that buys yield is VERY risk conscious. This is a trend I noticed with tax free bonds in the 90's.

With gas royalty trusts, especially canadian trusts, dividends correlate to price and volume with a pretty good lag factor. This makes them more predicible than other dividends though your GM example was about as predictable as they come.

Gas royalty trusts right now are undergoing the perfect storm of high drilling costs, falling gas prices and tax law changes in Canada. IMO, over the next year, drilling costs will lower, canada will make a special tax exemption and prices will skyrocket.

2007 Jan 03 10:03 AM

[Malkiel:]

Dividends became fashionable again last quarter as a lot of public buzz got generated among the talking heads on CNBC about how investors are rediscovering dividends and becoming unhappy with share buyback programs which don't seem to lift share prices. Expect companies to begin to align themselves with the zeitgeist, offering dividends where they hadn't before or upping them if they had. This means that your indicator has run smack into the fad of the moment and won't have much utility for the rest of the year as companies get their hands slapped for trimming dividends and decide it isn't worth generating the commotion...

2007 Jan 03 04:03 PM

[Panskeptic:]

Dividends have always been a major part of total return. The fact that people have woken up to the importance of dividends as part of the tech wreck hangover does not make it untrue. And even CNBC can get it right occasionally, even if by accident.

However, the orthodox religious doctrine that everybody knows everything and therefore it is impossible that a stock can be mispriced is patently untrue. Every transaction implies a difference of calculation concerning price.

As Mark Twain said, "Faith is believing what you know ain't so."

2007 Jan 03 05:00 PM