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What to Make of a Dividend Cut

By Roger Conrad on April 27, 2012

When a company you own cuts its dividend, should you sell?

That’s a question that inevitably confronts every investor in dividend-paying stocks, no matter how careful you are.

At the end of the day a company’s dividend is only as good as its ability to keep writing the checks. The greater the perceived risk to its dividend, the higher the yield investors will require to continue to hold the stock.

For nearly two decades I’ve tracked a “Dividend Watch List” in my Utility Forecaster advisory. The idea is to identify companies with elevated risk to their dividends so investors can make intelligent decisions based on the potential risks and rewards of holding on or even buying.

My criteria for inclusion are pretty simple. Basically, if a company isn’t consistently generating enough profit to cover its dividend–and has little prospect of doing so in the near future–it belongs on the Watch List. Equally, if a company is on the edge of what I would call a “revenue cliff” it must be considered at risk. Examples today include companies that produce natural gas and haven’t locked in future selling prices.

Debt can also be a major threat to dividends, particularly when credit markets are unsettled. For the better part of three years US corporations have been able to borrow at historically low rates. As a result they’ve been able to push debt maturities well into the future as well as refinance existing debt at extremely low rates.

Debt is still a threat to some US companies’ dividends, however, notably those facing a revenue cliff or earnings shortfall. Rural phone company Otelco (NYSE: OTT), for example, was forced to cut its dividend this week, when Time Warner Cable (NYSE: TWC) unexpectedly announced it wouldn’t renew an access contract with the company that accounted for 11.7 percent of revenue. That immediately raised the specter of a future cash crunch if the sales couldn’t be replaced, and the company cut its payout.

For the most part, however, debt isn’t a serious problem for US dividend-paying companies. And that’s particularly true of the US utility industry, which has spent the last 10 years cutting debt and operating risk.

By stark contrast, European dividend-paying companies are facing a harsh combination of extremely unsettled credit markets and slowing economies that are depressing revenue. Even these countries’ dominant communications, power and water companies are now at some risk, as they face the choice of either refinancing maturing debt at crisis-level interest rates or paying it off with cash from operations and/or saved through dividend cuts.

At any given time there will be 12 to 15 companies on my Dividend Watch List, out of a coverage universe of roughly 200. In normal times only a tiny handful will actually wind up cutting their payouts. The vast majority will simply exit the list after posting improved results.

By contrast, when macro conditions are more extreme, the pace of dividend cuts picks up as weaker companies have a more difficult time hanging in there. Moreover, when there’s one cut in a sector investors naturally assume there’s more to come, and the result is a selloff that spreads to the rest of the group.

Once conditions start to improve stocks of companies whose dividends really aren’t in danger generally do recover. That happened in the fourth quarter of 2011 with a vengeance, just as it did in 2009 following the all-encompassing crash of 2008. Those who assumed there was fire where there was smoke effectively sold out at abysmal prices, locking in losses only to watch their stocks recover and sometimes go on to new heights.

Accepting volatility is a normal part of investing in stocks. Sometimes it can get quite wild. But so long as the underlying businesses of your companies are healthy and growing, they’ll keep paying and very likely raising dividends. And as long as that’s the case, their stocks will recover from even the worst debacle. That means the best course is simply to hold on no matter how bad the near-term damage to the share price is. In fact, given that so many income investors are essentially buying and selling on price momentum–buying when prices rise, selling when they drop–the dips are frequently excellent times to buy.

But what if the companies you own do actually cut dividends? Can we still infer they’re healthy and poised for a rebound? Or is discretion the better part of valor, the wise course simply to cut your losses and move onto something else?

Unfortunately, there’s nothing cut-and-dried about the answers. For one thing, a stock that finally cuts its dividend will frequently drop in price before hand, as more investors bet on its demise. Then, once the cut is made the stock will sell off even harder, leaving it at an even lower price.

My general advice if you’re stuck with a dividend cutter is not to sell on the day of the announcement. Typically the action will be crazy, as institutions pile in and out and many people panic sell. Consequently, you’re almost always going to get a better selling price by waiting a few days.

Neither, however, should you be complacent and simply hold and hope. Rather, your first step should be to ascertain what you missed that led to the cut and determine whether your initial reason for buying in still holds.

There’s no such thing as perfect information in the stock market. Even the most skilled and experienced management team can miscalculate or find itself up against a macro environment that forces them to do something they definitely don’t want to.

Clearly, no management team ever wants to cut its dividend. The key question though is whether or not there’s worse to come.

Unfortunately, that’s not at all an easy question to answer. But here are a few rules that can save you a lot of pain.

First, if a company cuts its dividend there is a problem. If it’s not immediately clear what it is from management’s statements or other public information, you should sell. A sharp negative change in management guidance is also usually an indication to sell.

Second, if it’s clear what the problem is your investment has become a bet that the dividend cut will buy management enough breathing room to reach a solution for dealing with it. That’s very much a calculated risk. If you’re not willing to take it, you should get out.

Third, if you’re willing to take the calculated risk, then set benchmarks for determining if management is indeed resolving its problems. Recovery doesn’t happen overnight, and investors don’t forgive easily, so dividend cutting stocks can stay down for a long time. But there should be evidence that your bet is going to pay off. If the underlying business continues to deteriorate, you should be gone.

Fourth, always draw a distinction between movement in the stock price and genuine progress at the company that will safeguard the remaining dividend and restore its fortunes. Stock prices move basically on perception in the near term, which may or may not have anything to do with reality.

Fifth, never ever average down in a falling stock, particularly following a dividend cut. That will just make it that much harder to admit you’re wrong–and being able to do that is always the difference between taking a large loss in one stock and seeing a major hole blown out of your portfolio.

Finally, when you buy dividend-paying stocks, don’t put all your eggs in one basket. Setbacks are inevitable. But they do a lot less damage to a balanced and diversified portfolio than one that’s weighted to a few names.

Buying round lots (increments of 100 shares) used to be the only economic way to build a portfolio. Now you can buy individual shares of stocks on the cheap through dividend reinvestment plans.

No one likes to take a loss or find out a stock they own has cut its dividend. But dealing with both is very much a part of income investing, particularly at a time when cash yields are negligible and bonds are priced for perfection that’s bound to eventually disappoint.

Following these rules won’t prevent you from ever owning a dividend cutter or taking a loss. But they will limit the damage to your portfolio when one occurs, so you can continue to enjoy the best of what dividend paying stocks have to offer–safe reliable growth in dividends and share prices that builds wealth like no other investment in today’s market.

That’s how to maximize portfolio returns in 2012 and beyond.

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  1. avatar
    george Reply April 28, 2012 at 10:34 PM EDT

    What about Otelco???

  2. avatar
    pat Reply April 28, 2012 at 6:23 PM EDT

    So what do you say about OTT? Hang on to it or sell? It’s been on a decline for months on end.