Tags: Dividend | Cuts | Good

When Dividend Cuts are a Good Thing

Tuesday, 27 Dec 2011 08:27 AM

By Andrew Packer

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It’s one of the classic rules of investing: When a company cuts the dividend, run — don’t walk — away.

Like any other rule in investing, however, there’s a lot of flexibility. In fact, not all dividend cuts are bad. Some can even be beneficial to shareholders over the long term.

A dividend cut does two things. First, by reducing the cash payout, it increases the certainty of future dividends. No company wants to cut their dividend, as it’ll scare off long-term investors looking for an income. But if they have to, it’s best to do it once and get it over with.

Secondly, it reduces the price of the shares. In some cases, prices fall enough that the dividend yield ends up being higher for investors who waited to buy.

So the dividend cut itself isn’t all that matters. What does matter is the underlying performance of the company, and how the market reacts.

Investors who buy after a dividend cut might get a higher initial yield on their investment, and capital gains over time as the company recovers.

One such case may be Annaly Mortgage (NLY). This mortgage REIT makes money by taking advantage of low short-term interest rates to invest in mortgage securities. Today’s low interest rate environment should be a slam dunk for Annaly investors. The Fed is committed to keeping interest rates low, ensuring profitability for the company. However, mortgage prepayments are on the rise. That’s bad for Annaly’s profitability.

Of course, any company that suspends or eliminates its dividend likely has major problems, so that’s usually a situation where selling is best. But again, like any other “rule” of investing, it doesn’t work all the time. BP suspended its dividend in the wake of the Gulf oil spill. Shares sold off beyond any liability the company faced for the spill, representing a buy opportunity. Shares are much higher today, and the dividend has been reinstated (albeit at half the prior level).

If you’re investing solely for current income, then, yes, a dividend cut is a terrible thing. Anyone invested in banks during the housing crisis and credit crunch learned that firsthand when dividends got slashed to a penny or were simply suspended.

Ideally, investors should know about the danger of a potential dividend cut before management. Warning signs include a company that burns through cash, needs to sell off assets on a regular basis, and is already paying out a dividend in excess of earnings.

Over time, however, some companies facing short-term problems may need to cut the dividend to stay afloat. If they can recover and grow, then over time these troubled companies can go on to thrive.

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