Dividend Cut, What Do I Do?

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Includes: AAPL, ATGFF, BDIMF, BPL, BUD, CGC, CJREF, ENB, GE, LB, LQSIF, MSFT, OMI, QCOM, SHOP, SNCAF, STX
by: The Dividend Guy
Summary

A dividend cut is one of the worst things that could happen to a dividend investor.

If the dividend cut surprises the market, the stock drop will be immediate.

I always prefer to remain cautious and never invest more than 20-25% of my portfolio in a single sector.

A dividend cut is one of the worst things that could happen to a dividend investor. Sometimes, management decides to break their promise and fails their shareholders by slashing their dividend payment. When such an event happens, we are left with a big hole in our portfolio. A dividend cut is not only a reduction of your revenue but also leads to a capital loss. There are techniques to avoid dividend cuts, but no strategy is perfect. We can all suffer from a dividend cut. Today, I'll discuss how I manage dividend cuts in my portfolio. I hope it will give you a few tricks to manage yours.

Why does the company cut its dividend in the first place?

Interesting enough, there are many reasons why a company would decide to ax its distribution.

The first one is obviously because things are not going so well.

A company could face many headwinds at the same time and generate a lot less cash flow than expected. Imagine a company with new competitors, reduced margins, or stuck with a major scandal or callback. When an enterprise has a business model built around a factor it doesn't control (this is the case with many oil exploration companies), a sudden price move could also push the company to revise their budget. General Electric (NYSE:GE), Buckeye Partners (NYSE:BPL), Owens & Minor (NYSE:OMI), and Anheuser-Busch InBev (NYSE:BUD) all cut their dividend because of poor management.

Second, the business could need additional money for a specific project.

While a dividend cut is more often bad news than anything, it happens that it could become a strategic move. One of the most recent cases I saw this reason mentioned was with Alcanna Inc. (OTCPK:LQSIF) (CLIQ.TO). Alcanna Inc., formerly Liquor Stores N.A. Ltd., is a retailer of adult beverages and cannabis products. At the end of 2018, management announced they will scrap their quarterly dividend to focus on cannabis development.

Alcanna issued this statement about the policy change:

The company believes that it is in the best interests of the shareholders to invest all free cash flow in the growth opportunities available to the business which is expected to result in an increase in shareholder value over the medium term versus continuing dividend payments."

In most cases, the management team will try to make it sound like a good idea. It's a way to improve financial flexibility or to invest in new growth projects for example. They will sell you that by cutting its dividend, the company will become a better investment. In reality, the dividend cut is a result of poor management. Keep in mind a regular dividend payment is optional, but not an obligation by the company. Therefore, it's up to management to start paying shareholders and to increase its dividend over time. Poor budget management will lead to a dividend cut.

What is the effect of a dividend cut on my portfolio?

The last time I suffered a dividend cut in my portfolio was in 2015. From the best of my knowledge, I think it was the only one. It was when Black Diamond Group (OTCPK:BDIMF) (BDI.TO) announced its first dividend cut (more followed). As mentioned below, BDI business model was built around a factor the company has no control over with: oil price. The company specializes in providing workforce accommodation solutions ranging from basic accommodation unit rental to full turnkey lodging. The problem is that the bulk of its income was linked to the oilsands developments in northern Alberta. You can figure why management had to cut its distribution! Let's take a look at how it affected my portfolio (the full detail of the story is here).

Goodbye revenue!

The first impact a dividend cut has on my portfolio is a loss of revenue. If your shares you hold pay you $2K in dividend per year and they get cut by 30%, you are left with a revenue of $1,400 going forward. In my situation, I don't really mind now since I don't depend on my portfolio (yet) to manage my budget. But suffering 30-50% revenue loss on a few stocks could be catastrophic for a retiree.

Did anyone tell you about stock value?

What really hurt is that most dividend cuts come with a loss of capital. Therefore, you don't only lose future income, you also lose immediate money. And for some who think the stock can come back to its original value… well, it is also less likely to happen (note: I know there are exceptions).

Source: YCharts

In 2018, many well-known companies cut their dividend. Companies such as GE, Owen & Minors, Buckeye Partners, L Brands (NYSE:LB), Anheuser-Busch InBev, Artis REIT (AX.UN.TO), Corus Entertainment (OTCPK:CJREF) (CJR.B.TO), and AltaGas (OTCPK:ATGFF) (ALA.TO). All of them came with a stock value loss as well:

Source: YCharts

As I previously mentioned, you may follow a very solid dividend investing strategy. This doesn't mean you will never suffer a dividend cut. Here are your options when this happens.

Option #1 Don't do anything and hope

Don't panic. This is one of the most commonly spread investing advice, right? Buy low, sell high. If a company cut its dividend, chances are it will be in a "sell low" situation. Therefore, the rational way to treat this problem is to wait until shares price come back up. Unfortunately, stocks are not like tennis balls; they don't always rebound. History is filled with companies that cut their dividend, lost value, and never came back to their peak price.

Plus, trading on hope is a very bad investing strategy. I've previously wrote about what happens when you trade on hope; it's not pretty. Speaking of which, do you think the GE share will ever hit $40 or $60? If the dividend cut surprises the market, the stock drop will be immediate. Therefore, you can't really "get out of it fast and save your furniture". You must first accept the loss of both revenue and capital. Then, you must look at the company to know what happens. You can definitely wait a few days before making a decision. Don't worry; the stock is going nowhere once the announcement has been made.

Option #2 Buy more on the dip

One may be tempted to buy the dip and do some cost average. After all, you are already stuck with some shares at $10, why not buy more at $6 and get your average price down to $8. Then, once the stock bounces back, you will be able to sell them faster.

This strategy could make sense only if the company has a real plan to get out of this mess. In rare occasions, management is forced to cut or pause its dividend due to unfortunate or unexpected events. In those rare cases, it is possible to make a real gain out of a dividend cut. However, you may very well be falling in the "trading on hope" category. Make sure you are not investing your pension plan in such play.

Option #3 Take my loss like a grown-up

I personally prefer going with option #3: taking my loss and moving forward. Do you know what is worse than seeing its stock cutting their dividend and taking a loss? It's waiting five years for this stock to come back to a reasonable price and then sell it. Imagine you bought shares of L Brands for its yield at the beginning of 2018. Your average share price is $50 as you were smart enough to buy on the dip (it was trading at $60 at the very beginning of January). Today, you look at your shares and they're worth $27, a spectacular loss of 46% of your capital. Before it jumps back to $50 (and then you get no gain, but no loss), you need an investment return of 85% (going from $27 to $50).

In the next 5 years, do you think you have better chances of seeing LB surging by 85% or selecting another company that is currently growing and showing a strong balance sheet (let's pick Microsoft (NASDAQ:MSFT) for fun). The money you lost in 2018 is gone. Now, you can either wait and hope or you can take your loss like a grown-up and pick a company that has better chances of recuperating your loss in the upcoming years.

Here's what I did once I sold BDI.TO

Personally, I think MSFT has a lot more chances than LB to grow in the next 5 years. This is exactly what I did when BDI.TO cut its dividend. I sold my shares right after the first dividend cut and bought shares of Canadian National Railway (CNR.TO) (NYSE:CNI) instead. The rest is history:

Source: YCharts

While BDI.TO's problems continued and shareholders suffered more dividend cuts until there is nothing else to cut, CNR not only generated a 50% total return in my portfolio but increased its dividend by 72% during that period. When I look at both trades, I was able to recuperate my money lost on BDI.TO and get a stronger revenue three years after making that trade.

Back in late 2015, I wrote the following:

After the dividend cut, you can do two things:

  1. Drink management's Koolaid, refuse to take your paper loss and keep hoping it will all work out.
  2. Follow your investing rules and look forward to the next company on your watch list.

As you can see, my investing strategy didn't change much over the past 3 years. I remained focused on my 7 dividend investing principles and used them to pick a stronger company.

What happens if I wasn't a shareholder yet, should I buy?

In light of what I just wrote, I would definitely not be part of the catch-falling-knives party upon a dividend cut. I allocate a low proportion of my portfolio to make riskier trade such as catching a falling knife. I've had my shares of success doing so in the past (here's my technique). In the past few years, I've successfully done the trick with:

  • Seagate Technology (NASDAQ:STX) (after the flood in Thailand)
  • Apple (NASDAQ:AAPL) (before the split when the iPhone was doomed)
  • SNC Lavalin (OTCPK:SNCAF) (SNC.TO) (the first time they got caught for bribery, not right now)
  • Qualcomm (NASDAQ:QCOM) (upon their first legal problems with Apple)
  • Shopify (NYSE:SHOP) (when Citron Research pulled their stunt in 2017)
  • Canopy Growth (NYSE:CGC) (WEED.TO) (pick your drop… there were many!)
  • Enbridge (NYSE:ENB) (ENB.TO) (current position, the company isn't done with their issues)

Final Thought

As you can see, none of them include a dividend cut (but 2 trades were non-paying dividend stocks). According to my investing principles and my global strategy, I consider my crystal ball isn't strong enough to determine if a company that cut their dividend can make amend and bring back what has been lost. I don't have the stats (if you do, please share it with me), but my guess is that most dividend cutters (read 75%+) deliver mediocre results (below market returns) in the next 5-10 years following their dividend cut.

The reason why I was able to avoid most dividend cutters in the past 9 years (I started investing in 2003 but focused on dividend growth investing only in 2010) is mostly because I have a strict and effective methodology. I focus on dividend growth stocks that show several growth vectors. By using the dividend triangle, I'm rarely wrong about stocks I pick for my portfolio.

Here are a few tricks to avoid dividend cuts

A dividend cut announcement is definitely the worst news you can get as a dividend investor. It reduces your immediate source of income (the dividend) and it amputates a good part of your portfolio value. You want to avoid them at all cost.

My investing platform, Dividend Stocks Rock, will shortly celebrate 5 years of existence. I'm proud that none of our holdings have suffered a dividend cut in 5 years and only a handful of them missed increasing their payouts each year. In October 2018, we hosted a free webinar explaining our methodology to avoid dividend cuts.

We make sure each company we keep in our portfolios show the following characteristics:

  • #1 They are dividend growers
  • #2 They show growth vectors
  • #3 They show reasonable payout ratio (cash payout ratio or AFFO payout ratio)
  • #4 They don't pay a high yield (or we get very cautious)

If you want to learn more about those characteristics and how I look at them, you can read my quick guide to avoiding dividend cuts.

In the end, it is very hard to not be surprised by dividend cuts. I always prefer to remain cautious and never invest more than 20-25% of my portfolio in a single sector. Therefore, if I ever get "caught" by a "cut", it will hurt only a part of my portfolio and not most of my holdings. Because when things start to get sour in an industry, it gets ugly for everyone…

Disclaimer: I hold shares of AAPL and ENB.TO

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.