Over the last few months, there have been several articles that have discussed Dividend Growth Investing objectives and performance. In some articles and comments, I’ve seen the statements that: (1) DG investors care less about stock prices (capital appreciation / loss) than increasing income streams, and (2) market prices don’t reflect reality and it’s not a loss until you actually sell. I can understand the first statement, but my concern with the second is that if the firm cuts its dividend, then the reason for owning its stock is gone and presumably, the investor will sell it. At this point, the stock’s price has likely fallen significantly because of the firm’s issues and the dividend cut, so that “unreal” lower market price just became reality! This got me thinking…can we learn anything from the price that would help us to avoid this loss?
Efficient Market Hypothesis
In theory, the market price is rational and reflects all public information available at the time. Therefore, an investor should not be able to use prior information to generate excess gains because “everyone” could do the same thing. However, there are some anomalies with an efficient market hypothesis (EMH), which should not be possible if the theory was 100% true.
Research has shown that small-cap, value stocks outperform larger-cap stocks, and my recent series has highlighted how DG stocks have outperformed the overall market. In addition, the graph below (click to enlarge), illustrates how stock prices tend to continue declining after a bad earnings surprise. Based on EMH theory, one would expect the initial price drop to incorporate this entire decline.
My own theory is that information takes time to disseminate to all investors, and time is required to process it and make decisions. Some people need more time than others. This creates a window of opportunity to get out before the herd and minimize one’s losses. Assuming the same trend happens for a dividend cut event, this provides additional rationale for exiting a stock immediately upon a dividend cut announcement. I assume a DG investor sells a stock at this event, as his/her reason for owning the stock is no longer applicable. Of course, by this point, the price has already declined significantly.
Whether or not you believe that the market (i.e. all of us) is “rational”, the market price does reflect what people are willing to pay for a stock. This factors in business information, future expectations, macro concerns, and emotions (fear, exuberance, etc).
Can this collective market be “smart enough” to know when a business is failing and going to cut its dividend, even when irrational emotions are part of the equation? Could there be another anomaly to EMH? My inquiring mind wanted to know, so I decided to analyze price changes prior to dividend cuts to see if there were any patterns that could help investors to anticipate a future dividend cut.
Luckily, I already had a list of non-financial, US, $500MM+ market cap DG firms from 1999-2010 that had cut their dividend from a prior research study. I combined this list of 40 stocks (there weren’t that many) with the stocks from Robert Allan Schwartz’s recent article on Dividend Champions’ stock performance (2007-2010), which included many financials that cut their dividends. I admit, this is not an all-inclusive universe, but I believe it is large enough to be a decent sample. I excluded a few firms that cut their dividend because of spin-offs or buyouts, as investors likely didn’t suffer from these events.
Some statistics about this universe:
- There were just 56 firms that cut their dividend, excluding spin-offs; see the list at the end of the article.
- 22 were Financials (39%), 13 Cons Discretionary (23%), and 6 Industrials (11%). This correlates with sectors that have higher betas. If you want to avoid dividend cuts, the preemptive move is to underweight these sectors. Note: The financial percentage is likely low, since financial Dividend Contenders and Challengers were not included, but it doesn’t change the relative ranking.
- The sectors with the fewest cuts were Telecom (0), Info Tech (0), Health Care (1), Energy (2; 4%), and Materials (2). Some of this may be because there aren’t many stocks from these sectors in the dividend growth firm lists to begin with. However, telecom and energy are like utilities (stable) and info tech firms typically have low debt (more flexibility), which may help to avoid cuts.
- 8 of the 56 cut their dividend by 90-100%. Of the other 44, 14 (32%) cut their dividend a second time. The overall average dividend cut was around 60%, comparing the quarter-to-quarter change.
My previous research project utilized multiple regressions on all sorts of financial metrics to construct a formula for predicting dividend cuts. I pursued something simpler for this effort. If a firm has to cut its dividend, then it should be in financial trouble. Assuming the market knows this, the stock’s price should decline faster than the market as a whole. So, I decided to search for instances where the stock’s price had a 2000-basis-point (20%) lower performance than the S&P 500 (SPY). I chose 20% because I didn’t want intermittent price “noise” to inadvertently signal a cut; I wanted to be sure the stock was performing worse. Lowering it to 15% did improve results a little, so the optimal value is up for debate, but I’m sticking with 20%. I also required that this poor performance be sustained for 4 consecutive weeks before counting as a signal to avoid temporary blips.
My final process involved the following steps. I looked up the announcement date for the stock’s dividend cut. For 6 stocks, I couldn’t find the date, so I used one month prior to the cut’s ex-div date as an estimate. Next, I pulled up a chart in Google Finance for the stock and S&P benchmark (SPY), starting one year prior to the announcement date. I then analyzed the chart, looking for a sustained (4-wk, using weekly data) -20% gap between the S&P return and the stock’s (price) return. If none was present, I also checked a 6-month prior chart. Obviously the starting date matters, as percentage returns are based on the starting prices, but these two checks proved to be rather informative. For stocks that had a -20% gap, I estimated the price at the end of the 4th week, which represents the exit price if the investor followed this signal and sold the stock. I also recorded the price at the dividend cut announcement, and the current price for comparison.
Of the 56 stocks in the Div-Cut Universe, 38 (68%) had a 4-week or more -20% performance gap versus the S&P 500 prior to the dividend cut announcement when starting one year prior to the announcement. Including 6-month charts, this number rose to 42 (75%). Using a 15% gap criteria, it rose to 46 (82%). Perhaps price movements can tell us something! The remaining stocks went undetected by this test, which isn’t surprising; I wouldn’t expect any criteria to be 100% perfect. This is a huge improvement over the standard “sell when the cut is announced” system.
For the 42 stocks that met the -20% gap criteria using 12-mo or 6-mo charts, I estimated the price at the gap and compared it to the price at the cut announcement. On average, an investor saved 22% by selling at the gap signal instead of selling at the announcement. Not all stocks declined however. 19% experienced a price increase, with an average increase of 8.7%, while 81% had no change or declined with an average decline of 31%. Sometimes the price increased at the announcement. Management action can be taken as a positive sign, especially if investors had already been expecting the cut. While DG investors may value dividends over appreciation, saving 22% is equal to around 4 years of dividends, assuming an 5.5% avg yield. If the investor can find another stock with a comparable yield to invest in, avoiding this loss is a plus.
Comparison to Sector Indices
I wondered if it was fair to compare each stock to the S&P 500, since some sectors have higher beta, which would imply greater price movements. When I analyzed the stocks against their respective sector ETF, the results did not correlate as well; only 26 of 56 (46%) dividend cuts were detected.
Summary and Next Steps
With ~75% of dividend cut stocks being identified in advance of an announcement, based on a -20% gap in price performance versus the S&P 500, it appears that we can glean information about future dividend cuts from price movements. This provides an important reason for DG investors to care about price and a different way to think about price changes. In addition, acting upon the signal of a 15-20% gap in performance versus the S&P 500 could help investors to avoid a larger loss in the event of a dividend cut.
However, there is another piece to the puzzle to explore. How often does this signal incorrectly flag a stock? That is, when is there a -20% performance gap, but the dividend and/or price continues to increase? This will be the focus of the next segment, as I test this theory on current Dividend Champions.
Dividend Cut Stock Sample Group 1999-2011:
ACV, AM-OLD, DHI, F, HOG, LZB, MAR, MAT, MOD, SCI, IPG, NYT, GCI, CAG, BEAM, RAD, SLE, SVU, SUN, VLO, ASBC, BAC, BBT, CHFC, CMA, FITB, FMER, FULT, KEY, LM, LNC, NPBC, ONB, PEBO, RF, SLM, STT, SUSQ, SNV, UDR, USB, WFSL, PFE, AVY, GE, KELYA, MAS, PLL, ROL, IFF, VMC, CEG, SCG, TE, WEC, XEL
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.