Sometimes dividend cuts are good signs

The communicated and executed dividend policy of a publicly-traded company is an important factor to consider when it comes to investing in income-generating assets.

An immanent dividend cut for instance is often a warning sign that the business is running into troubles, that it has been applying an unsustainable dividend policy which has not to be on the basis of sound Free Cash Flow generation.

We have covered on this website several enterprises that managed to hike their shareholder distributions for decades. Companies like Hershey, Swiss pharma giants Roche and Novartis, or for instance, or The Coca Cola Company that belongs to the so-called Dividend Kings, showing over 50 years of climbing cash flows for their stockholders. Or Swiss food giant Nestlé and French cosmetic giant L’Oréal that have managed to increase their top-and bottom-line consistently year by year, making it possible to apply progressive dividend policies since 1986 in the case of Nestlé and since 1988 for L’Oréal.

So, for long term oriented income investors, it’s, of course, beneficial to have Dividend Aristocrats (at least 25 years of growing payouts) and even a few Dividend Kings as backbones of their investment portfolios, providing stability not only in terms of long term performance but also on the cash inflow streams.

But dividend growth investing does not necessarily mean, that one just has to focus just on these companies. There are plenty of wonderful businesses that have a bright future and show compelling growth that is “just” Dividend Achievers, showing “only” eight years of hiking dividends. You can find Microsoft or Apple in that group.

When constructing a dividend portfolio, it makes a lot of sense to find a good mix of

  • businesses that belong to the Dividend Aristocrat Group (at least 25 of hiking dividends),
  • some strong growing companies that have applied a progressive dividend policy for at least eight years (Dividend Achievers)
  • and equally important: potential future dividend payers with excellent growth prospects and compelling financial profile such as Facebook and Alphabet.

Dividend growth investing works best, when it is long-term oriented when we focus on the next decades to come.

What we want to do is planting the seeds today for future dividend and book value growth. We can’t just put our focus on the past or the present and look at the best dividend payers we find in the market now. We have to apply some vision on how our dividend portfolios could look in the future.

So, with that being said, each dividend growth investor will be confronted with one or a few holding positions that is set to cut or eliminate the dividend.

Yes, we all have our “red flags”, we focus on the Free Cash Flow, we tend to see macro-events, etc., but still: sooner or later it will be inevitable to see drastic changes to the dividend policy of a few companies in a diversified portfolio. That’s just the basic truth. If you don’t want to see such an event, you have to invest in Index Funds, an ETF and don’t look at the businesses this Fund is investing in.

There will always be developments and events that will put pressure even on excellent businesses, forcing them to re-consider their dividend policies, to take the tough decision to drastically reduce the shareholder payouts, or even eliminate their dividend payments for a few years.

It happened for instance amid the COVID-19 pandemic in 2020, where e.g. The Walt Disney Company or LVMH changed their dividend policy and temporarily stopped payouts in order to preserve cash and to be able to invest heavily into their core businesses and/or to make acquisitions. The Walt Disney Company invested in their streaming services, namely Disney+, and is now a major player in this area, even now challenging Netflix. And LVMH pushed its online distribution channels amid the COVID-19 lockdowns around the world and acquired its US competitor Tiffany.

There are plenty of such examples with businesses that came out as winners after a dividend cut, such as car rental company SIXT that literally thrived amid huge economic pressure.

So, the company- and stock market history shows that a dividend cut is not always a bad thing. Investors should be aware of that fact and react and position themselves in a flexible way.

An imminent dividend reduction is a “red flag”, don’t get me wrong. It requires immediate research on the position we are holding. But it is not always a reason to throw businesses out of an investment portfolio. Let’s just look at two other examples for illustration:

From 2014 to 2016, amid a “commodity price crash”, Anglo-Australian mining giants Rio Tinto and BHP Group (former name: BHP Billiton) came under enormous pressure when prices for iron ore, oil, etc. plummetted. Having been generous dividend payers for decades and having applied a progressive dividend policy for years, Rio Tinto and BHP Group were hesitant to slash their dividends and first streamlined their operations and cut their capital spendings drastically. But the business reality can be tough, and even the strongest and largest mining companies such as Rio Tinto and BHP Group eventually had to cut their shareholder distributions, to preserve cash and avoid to over-leverage their balance sheets.

This step was prudent and it turned out that Rio Tinot and BHP Group came out as long-term winners. Several mining companies had to undergo fire-sales of their assets when heating pressure from credit rating institutes literally forced them to take drastic measures and dispose of parts of their businesses. Rio Tinto and BHP Group just a few years later re-instated their generous dividend payouts and rewarded their investors handsomely. Commodity prices had recovered, and the strongest players in the sector had used the preserved cash to de-leverage and optimize their cost structure which resulted in a huge boost to their bottom lines when sales recovered.

A dividend cut often has a psychological effect, but the measure per se does not deteriorate the balance sheet. It can have a negative implication e.g. if communicated poorly and causes selling pressure on the stock price etc.

Personally, I have a hard time understanding the dividend policy of ExxonMobil for instance, one of the strongest oil supermajors in the world. Amid lower oil prices, that company has taken on debt, slashed costs like crazy, drastically reduced capital spendings just to preserve its dividend policy. Is it really worth it, just to be in the illustre league of the Dividend Kings? I mean the businesses model very obviously does not support such a progressive dividend policy.

Businesses should protect their employees, their balance sheets, their economic moats, etc. A dividend policy does not have a purpose of its own. Prudent managers with a long-term vision see that.

And yes, a dividend cut can be a very good sign that management is taking a prudent approach consistent with the business reality and that the enterprise is getting ready for the next stage of growth.

Disclaimer
You are responsible for your own investment and financial decisions. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action.

About Savy Fox

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4 comments

  1. You make some really good points.

    I decided to sell Disney at the time, because it announced to not pay a dividend for a while and it therefore stopped to be attractive for me. I bet already on FaceBook from a growth point of view and it has done me pretty well. Maybe one day I’ll get back into Disney, but not for now.

    On the other hand I decided to keep Royal Dutch Shell last year, because I saw the dividend as a much needed reset. I was definitely not happy with it, but I thought that it was good and prudent to do. 1 year later and we can see how the company gained financial flexibility and returned to growing their dividends.

    Every such dividend cut needs to be reassessed on whether it still aligns with your philosophy. Automatically selling is not something i’m a big fan of, but it can be a bit easier to apply, because it leaves emotions out of the equation.

    Thanks for making me think again about this 🙏

    • Hi European DGI
      Oh yes, Facebook is on my personal list of companies where I would not be surprised at all to see a dividend initiated.
      Fully agree, each dividend cut in a portfolio position requires to be assessed, it’s not rare it is a serious red flag. But of course it can also be a prudent, clever move to grow stronger in future. SIXT, Disney, LVMH etc. were right to substantially reduce their shareholder payout and instead invest aggressively in growth.
      Appreciate you stopping by and commenting.
      Cheers

  2. Hi,
    Your blog is awesome. I love to read your post. I appreciate you to continue your hard work. Thanks for sharing your knowledge.

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