It happens almost daily.

A business is clicking and generating ample cash flows with a promising growth trajectory ahead. After crunching some numbers and looking at forecasts, management generously decides to start sharing a bit more of the projected surplus with investors.

That’s right, a dividend hike. Naturally, the market cheers.

Unfortunately, there may later come a time when the same business cools and earnings begin to falter. Maybe the balance sheet is getting a little stretched. Given the uncertain outlook, the board prudently decides to preserve cash and rein in spending for a while. All too often, that means rolling back dividends.

Cue the wailing from the investment community.

Every business cycle ebbs and flows, and earnings rarely march in a straight line. Since dividends are largely tied to cash flows (a moving target), distributions must occasionally be adjusted up or down to reflect current operating conditions.

The upward adjustments are just fine. We saw nearly 2,500 of them among US-listed stocks last year, according to S&P Dow Jones. S&P 500 companies alone dished out $629 billion, a healthy 7% increase – and a new record high.

It’s the downward resets that cause so much consternation. And they happen all too frequently, even in favorable business climates. In fact, more than 400 U.S. companies were forced to reduce their dividends in 2023, including stalwarts like Intel (NSDQ: INTC). Last year brought another 150 cuts.

As we speak, some businesses take a step forward while others take a step back. That’s one of the few constants in the financial world. The only variable is the ratio between the two — which can (and does) vary greatly with the economic weather.

While we assiduously seek to avoid them, the occasional dividend cut is almost inevitable for income investors. While some can be seen coming a mile away, others are a bit of a shock. Either way, it’s usually not the end of the world. Often, these tweaks are the healthiest and most appropriate course of action.

When demand slumps (or capital priorities change) temporarily dialing back distributions may be the best solution. Nevertheless, these announcements almost always invite harsh backlash and overreaction.

Wendy’s (NYSE: WEN) stock has skidded into single-digit territory since the burger vendor slashed quarterly payouts from $0.25 to $0.14 per share a few months ago. Unfortunately, we must sometimes be willing to endure these kinds of bumps are bruises, right?

Not necessarily.

Most companies seek to maintain a fixed dividend, letting the payout ratio (distributions/earnings) bounce around. But when the denominator becomes less than the numerator, there’s a problem. Businesses can’t pay out more than they take in – at least not for long.

Sooner or later, look out below. Here comes a dividend cut.

Case in point, Dow (NYSE: DOW) distributed $2.80 per share in 2022, supported by net earnings of $6.28 – a comfortable payout ratio of 45%. But in 2023, earnings slid below $1.00, not nearly enough to meet the dividend. The payout ratio shot up above 300%, a bright red flag.

Sure enough, the chemical producer cut its quarterly payout in half (from $0.70 to $0.35 per share) six months later, triggering a painful 17% stock decline that day.

This is a business whose annual earnings oscillated from as much as $8 to as little as $1 in the span of two years. That’s a wide swing from peak to trough. So where do you set the payout? Offer too little and the stock isn’t very attractive to investors. Promise too much and the checks might bounce one day.

Hence the frequent tinkering.

Rather than try to maintain a fixed per-share distribution, what if the company decided to anchor the payout ratio instead. Maybe it decides to peg dividends at 50% of profits. That means shareholders would take home at least $0.50 in the harshest conditions and up to $4 when earnings peak.

Such variable distribution policies are quite common in Europe, but haven’t quite caught on here in the U.S. That’s because American investors are accustomed to seeing levelized payments every 90 days.

But is it possible to placate stockholders with a reliable, fixed dividend and still reward them with an extra bonus when earnings are soaring? That’s the best of both worlds.

It’s not just a hypothetical scenario. Several holdings within my High-Yield Investing portfolio have adopted this capital return framework, including ConocoPhillips (NYSE: COP).

The upstream oil producer brings more than 2 million barrels of oil per day to market. Clearly, it can afford to pay out much richer dividends at $80 per barrel than it can at $40. We’re close to the middle of that range right now, with benchmark WTI oil fetching about $62 per barrel.

Like its peers, ConocoPhillips has de-emphasized growth spending and pledged to return more surplus profit to stockholders. The question is how much more? As we know, hiking too aggressively (while great today) runs the risk of a future cutback the next time oil prices go into a protracted slump.

It’s not rocket science.

Trying to maintain fixed dividends can be tough when commodity prices are constantly bouncing around. So management has put the perfect solution into practice — adopting a three-tier return of capital program.

The first tier is a sustainable base dividend initially set at $0.46 per share (about $2.4 billion per year). This amount can be comfortably met even when oil prices soften and shouldn’t need to be adjusted except in extreme circumstances.

Even during the first quarter of 2020 (the early stages of the Covid lockdowns when global oil prices sank into the $30s), COP’s operating cash flows were still running at an $8 billion annual pace. So the $2.4 billion base commitment is an easy hurdle to clear.

That brings us to the second tier, a variable return of capital (VROC). The overriding goal is to return more than 30% of operating cash flows. So if regular dividends consume 20%, then variable dividends will make up the difference and comprise the remaining 10%. Give or take

This plan was first enacted in 2022. Between the three tiers (stock buybacks would be the third), the company dished out $8+ billion to stockholders that year. And then in 2023, it distributed $5.6 billion in regular and variable payments plus $5.4 billion in buybacks, for a hefty total of $11 billion.

Incidentally, shareholders were treated to 6 dividends that year – four ordinary and two bonus.

Since then, the ordinary quarterly dividend has been raised twice, first to $0.58 and most recently to $0.78 per share. As a result, management is aiming to return more than $10 billion to stockholders through this variable framework in 2025.

And that’s with lackluster crude prices.

With no expectation of four equal payments each year, there is no punishment when the payouts deviate. I would further argue that the inflexibility of maintaining fixed dividends (and avoiding said punishment) can even translate into missed growth opportunities, potentially dragging down returns on invested capital.

That’s yet another reason why we are starting to see more companies (particularly in industries with elevated cash flow volatility) embracing the merits of variable dividend plans.