I recently wrote an article on SeekingAlpha that explained my opinion on why it can be foolish to adamantly refuse to ever sell a stock, and why over-focusing on dividends is to ignore the many other shareholder enriching ways that management can deploy capital. This article was received controversially, to say the least, and has garnered 814 comments to date. Following is a paragraph from that article that will be my focus today:
In all my talk about not being afraid to sell, I feel it necessary to mention another rule that some people have as part of there investment strategy that I consider to be extremely short-sighted. There are those who sell a stock if the dividend is cut. No questions asked and immediately. I believe that this is incredibly hasty, as sometimes companies have remarkably good reasons to reduce the dividend. In other words, they found better places to put that capital. While further research would be warranted to see if the cut dividend is a result of an irreversible and severe deterioration of business fundamentals, selling before doing that research is not good investing. It is reactionary. So while I of course believe that no one should have a rule against selling, I also think you should have darn good reasons for selling. And a cut dividend isn't necessarily a good reason to sell.
In the review process before publishing, the editors encouraged me to explore this point, as it was weak without any evidence or examples. Today my intent is to use case studies to show that further due diligence is often necessary before choosing to sell a stock simply because they cut their dividend. Knee jerk reactions can result in real opportunity cost, and if the decision to sell a stock is hastily made before looking into whether or not that dividend cut was necessary or even wise, profits may be forfeited. To put my bottom line up front, smart managers are wise capital allocators, and wise capital allocation sometimes means diverting funds away from a dividend and towards other shareholder enriching activities (pay down debt, weather a storm in the commodity market, build up cash for mergers or acquisitions, buy back stock opportunistically, etc.)
DISCLAIMER: My point today is primarily for those whose goal is to beat the market from a total return perspective. For those whose goals are different my comments may be less applicable. Nevertheless, I feel that all can use this information to color their opinion on when to buy, sell, or hold a stock.
*image from from ianchadwick.com
Royal Caribbean Cruise Line (RCL) saw sharp declines in demand in the face of the 2008 financial crisis. Naturally, a luxury cruise is hardly a place to spend money when many struggled economically or were at least uncertain of their economic future. As a result, and to shore up resources until economic recovery was clearly underway, the company suspended the payment of any dividend starting in Q4 of 2008. Up to that point, RCL had paid a dividend that had grown decently over-time, from $0.28 in 1997 to $0.60 in 2007, a CAGR of nearly 8%. As measured from December of 2008 (when the dividend was cut), here is a chart of returns since then:
Capital gains are phenomenal alone. Additionally, after re-instating the dividend in July of 2011 at $0.10 a quarter, they have been able to grow it beyond the 2008 highs. The dividend declared just a few months ago in September was $0.70, a CAGR of over 20% since being re-instated. Compared against the S&P with dividends reinvested, RCL has returned ~30% per year vs. the S&P's ~15%. This is prime example of how sometimes a dividend cut is a result of macro-economic factors that having little to do with underlying business quality. This is a fine instance of judicious management knowing both how and when to deploy capital or NOT deploy capital in order to weather an economic storm. If you had sold RCL as a result of the dividend cut, you would have missed out on total return double that of the market average.
I can already hear the protests: "this is a poor example because RCL is a not a dividend growth investment. People don't buy it for the dividend, so they wouldn't necessarily sell it because of the dividend cut." I do concede that point, but there are a lot more examples, and some of them ARE from securities that people do in fact invest in for the dividend.
Back in 2015, commodities got crushed across the board. Naturally, any company that dealt in the exploration, excavation, production, and refinement of commodities saw sharp declines in profitability. BHP Billiton (BHP) is involved in petroleum, copper, iron ore, and coal segments, so they were especially exposed to the fall. In spite of repeatedly iterating their commitment to the growing dividend, the squeeze eventually necessitated the move. The dividend was sawed by almost 3/4ths. Up until then, the payout had not been reduced since 1988 and had grown for 15 consecutive years. This was certainly a company that people had invested in for the dividend.
Mr. Mackenzie, the CEO, said the change to the dividend policy would make the miner more capable of buying assets if good opportunities come onto the market:
"It allows us a lot more flexibility and optionality if you like in how we use our strong cash flow so that we can take advantage of what we think will be a number of critical opportunities at this phase in our company's development," he said.
Had you sold BHP or not bought it due to the cut dividend, had you turned a blind eye to the fact that most of BHP's problems were cyclical issues (a dam breach at a mine notwithstanding) and not necessarily related to the efficiency of operations, you would have missed out on returns that doubled the market on an annualized basis. As measured from the day of the announcement to cut the dividend on Feb. 22 2016, BHP has returned 105% (30% annually) vs. the S&P's 46% (15% annually) over the same time frame (dividends for both are assumed to be reinvested). Even if you back things up to before BHP bottomed and there were the first rumblings of a dividend cut back in October of 2015, you still would have beat the market with a return of ~49% vs ~41%. Here again the fact is that sometimes cutting the dividend is wise. The commodity crisis recovered in short order, and BHP is now paying a dividend that was higher than the pre-crisis payout, $1.26 vs $1.24.
The financial crisis left no bank untouched. Wells Fargo (WFC) was no exception. On Mar. 6 2009 they reduced their quarterly dividend from $0.34 to $0.05. This after paying an annually growing dividend for over a decade. But the $5 billion in yearly savings from cutting the dividend was important in context of evaporating assets as the housing bubble burst, taking mortgages along with it. We could get into the weeds about which assets WFC should or should not have bought, but needless to say the dividend cut was necessary. It should also be noted that the cut came after confident language only a month prior:
Given our strong balance sheet and business momentum, the Board of Directors declared a common stock dividend of $0.34 per share.
Of the dividend cut management said:
"This was a very difficult decision but it's absolutely right for our Company and our shareholders because it will further strengthen our ability to grow market share and to continue our long track record of profitable growth."
Had investors kept their wits about them and recognized the opportunity to enter or add to an existing position at ultra-depressed prices, they would have realized a 23% annualized return against the 17% S&P to date as measured from the day of the announced dividend cut. Furthermore, WFC has grown the dividend since then to exceed the pre-crisis payout. The latest declared dividend was $0.43.
My article today is not intended to suggest that you should never sell a stock that cut their dividend. Sometimes dividends get cut because the business is falling apart and internal and fundamental aspects of the enterprise are washy. That probably means sell unless you specialize in turnaround situations. But those signs often show up in the tea leaves long before a dividend gets cut, which reinforces the need to always stay on top of due diligence in reviewing portfolio holdings. And my article is particularly timely in context of General Electric's (GE) dividend cut, though I myself have done no due diligence to figure that situation out. The point is that sometimes a dividend cut is in fact a buying opportunity or a chance to lower the cost basis as people reflexively sell just because their sacred dividends were sacked. This is an aspect of contrarian thinking. If a business announces a cut dividend, look under the hood and determine whether or not the root cause of the dividend cut is due to factors outside the entities control, and/or from which they can recover. If that determination is made, think about buying. Wise management allocates capital wisely, and sometimes wisdom requires a dividend to be reduced or eliminated in order to shore up resources to weather a storm and have the liquidity to take advantage of opportunities in the market when scares strike. Dividend worshipers will give away their shares for a bargain in those conditions, and savvy folk who understand the MANY ways in which capital can be allocated to reward shareholders will find themselves with potentially market beating returns. Bottom line, "they cut their dividend" is sometimes a poor reason for selling a security. Having a hard and fast rule whereby you sell a stock no matter what just because the dividend was cut is hardly nuanced and extremely hasty. At least in the cases of the examples I shared, the dividend cut was very close to the bottom in the share price. Dividend cuts may therefore be a strong indicator for what value investors are aiming to do: buy low. Furthermore, cut dividends can in fact appeal to dividend growth investors, as dividends resume once the storm has passed and can grow healthily due to the prudent move to cease a payout for a time. It helps me to think of this all parallel to how I run my own finances. It times when cash coming in goes down (for whatever reason), if I want to stay solvent and financially fit I have to reduce what goes out. Or even if what is coming in stays the same, I may occasionally stop spending in one category (perhaps eating out) to increase spending in another (save for a vacation) because that is what I feel is best for my family. Those choices allow me financial flexibility in the long run. Corporations ought to act in the same way. A dividend cut simply means they are reducing what is being spent in the event that not as much is being earned, or they have better places to spend the money. People look at individuals as foolish for maintaining a spendy lifestyle when they don't earn much, but those might be the same people that get upset if corporations don't maintain a spendy lifestyle by cutting or not growing a dividend. They worship dividends and consider it sin for corporations to cut one, a sin worthy of selling, even though the corporation may have far better uses of the cash. To conclude, I used these examples to show that dividend cuts are nuanced, and should be researched before making either buy or sell decisions.
Disclosure: I/we 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.