Investing in Companies that Reduce Dividends

There are different schools of thought regarding dividends and equity investing. Depending on your personal opinion on the matter and the importance you assign to dividends, your approach to buying (or holding) the stock of a company that reduces its dividend will vary. Here we’ll consider both sides of the issue.

First, some basics: A dividend is the means a company uses to share its profits with its investors, since every shareholder is technically a part owner of the company (though usually that part is very, very small). However, companies are not required to pay dividends, and a majority of public firms do not.

Typically dividends are paid quarterly as a cash dividend of a fixed amount per share. If you own 100 shares of Wells Fargo & Company (WFC) which has a dividend of $0.12, you would receive a payment of $12.00. A company may elect to instead pay a stock dividend, in which shareholders receive additional shares, or—much less commonly—a property dividend, in which the company actually distributes property such as merchandise.

It follows, then, that a dividend-paying company will produce income for the investor even if the stock price fails to appreciate. However, that income is quite small unless you own a massive number of shares, and what’s more, dividend income is taxed at a higher rate than the capital gains produced by price appreciation.

For that reason, many investors consider dividends a relatively insignificant factor in the stock selection process. Dividend stocks are a poor choice next to fixed-income investments, since the company’s board of directors controls the dividend payment, and a company may reduce or eliminate its dividend at any time. (In 2008, as the financial crisis hit, 61 companies in the S&P 500 reduced dividends, eliminating over $40 billion in payments, and as the crisis hit its nadir in early 2009, $30 billion more was eliminated in the first two months of the year.)

Many investors would prefer to see the money used for dividends reinvested in the company instead, prompting (at least in theory) an increase in share price.

However, some investors consider consistent dividend payments an important sign of a stable company. This group is less concerned with the financial reward aspect of dividends than it is with their symbolism, though an argument can be made that a company which begins paying dividends has achieved a certain status and will see its stock price appreciate accordingly.

Of course, plenty of quite respectable companies refrain from paying dividends for sound reasons, usually because they’re pumping cash back into growth. Microsoft, for example, did not begin paying dividends until 2004—and it was clearly a powerhouse long before that.

There is certainly some validity to viewing dividends as an indicator of financial health, and that is the aspect we’ll consider since it directly impacts the advisability of investing in a company that has recently reduced its dividend. The bottom line—and this is not a cop-out—is “It depends.”

It depends because there are various reasons a company might cut its dividend. Broadly speaking, there are positive reasons—the company is responding to a general economic downturn or specific challenges and needs to conserve cash—and negative reasons—the company has gotten itself in financial trouble and can’t afford dividends any longer. One is a proactive management action; the other is just bad news. In other words, you need to dig more deeply and uncover the full story.

The first step is to examine the dividend cut announcement. Any company reducing its dividend will issue a press release, and that release will contain an explanation of the cut. How transparent and informative that explanation will be is another story, of course, but it does give you a starting point. Evaluate how sensible and, quite frankly, believable management’s story is.

The next step is to look at the company’s financials. What is the debt picture? Long-term debt should be less than half the company’s capital; ratios higher than that are a trouble sign. Trends—historical and predicted—are also important. Have the company’s revenue and net income been flat, increasing, or decreasing? What are analyst expectations for the future?

If it appears that the company has just hit a rough patch and will recover, a dividend cut or elimination can be a positive sign that management knows some belt-tightening will be necessary to get through the hard times. In that case, you may be able to pick up the stock at a discount, though this will be a long-term buy in order to allow time for recovery and reinstatement or increase of the dividend.

On the other hand, if future prospects are dim or the company has badly overextended itself and loaded up on debt, the dividend cut may have been a desperate measure. In such cases the company may have previously made dividend payments late, which just as with a debtor is a sign that no payment may be just around the corner.

Don’t automatically treat companies that have cut dividends as pariahs. Take the time to learn the whole story before making a decision, and you may find some diamonds that, while not in the rough, just need a little polishing to regain their shine.