The Smart Investor’s Playbook for Avoiding Dividend Cuts

By most measures, dividend payments serve as a crucial indicator of a company’s financial health, its ability to generate consistent profits, and its long-term growth prospects.

If you are an investor who particularly employs a fixed income or hybrid portfolio relying on income-generating assets, then you should view dividends as a steady source of income, which reflects the stability and predictability of the underlying business that is generating the dividends.  

However, a major warning sign for your attention shall be the cutback or altogether elimination of dividends, known as dividend cuts, which can indicate potential financial distress or a strategic shift in priorities within the company. 

Such shifts not only impact the investor’s portfolio but can also lead to a reassessment of the stock’s value by the market, often leading to a selloff and, subsequently, a decline in the share price. Thus, you must understand the implications of potential dividend cuts and how to spot a company that could cut dividends before the event takes place. The vital point is avoiding dividend cuts before they happen.

Identifying Warning Signs of Dividend Cuts

What are Dividend Cuts?

A dividend cut is an event when a company reduces or completely eliminates the regular dividend payment to its shareholders. This is often seen as a negative sign since it can signal the financial instability of a company. Following the dividend cut, it is often that the stock price depreciates as well.

Although it is usually viewed negatively, there could also be a strategic dividend cut when the company wants to redirect the capital to development purposes, such as the building of new facilities, or when they want to repay debt during a high-interest rate environment.

Factors Influencing Dividend Cuts

Payout Ratio

Investors need to anticipate and identify potential dividend cuts in advance to safeguard their portfolios. A key measure to keep track of is the payout ratio, which is a proportion of earnings paid out as dividends. If a company has an unsustainably high payout ratio, it may indicate that it is overextending itself. 

Other Financial Indicators

Furthermore, there are other factors to monitor, such as if earnings are declining year over year, if the debt is rising, and if the free cash flow is significantly deteriorating, which all point to financial strain on the balance sheet that may ultimately lead to a dividend cut. 

Economic and Business Cycles

Market trends also play a role in dividend growth, reduction, or suspension. For example, cyclical fluctuations in industries like energy or consumer goods can influence a company’s ability to maintain dividends.

During recessions, even the most robust companies might reduce or suspend dividends as a cautionary measure to preserve cash and shore up their balance sheet.

Technology Obsolescence

There are other sector-specific risks, such as the obsoletion of technology, which can lead to falling hardware sales for appliance makers, or the regulatory changes in the pharmaceutical industry that can adversely affect profits and, consequently, dividends.

Aggressive M&A

Other decisions, such as pursuing a series of aggressive mergers or acquisitions at the cost of overleveraging the balance sheet, can lead to a strain on the company’s financial resources and ultimately lead to dividends being cut or suspended.

Analyzing Financial Statements for Red Flags

Investors need to scrutinize a company’s financial statements to predict how the company will pay dividends and if it will cut dividends in the future. When the dividend payout ratio of a company exceeds 100%, it is a telling sign since it is paying out more than it earns. 

Another crucial metric is the free cash flow, which represents the cash a company generates after accounting for capital expenditures. If the free cash flow is declining or negative, it may eventually compel a company to cut dividends to preserve capital. 

Measuring a company’s leverage to understand its financial health using the debt-to-equity ratio is also important. If a company has a high debt-to-equity ratio, it may prioritize debt repayments over dividends in the future, especially if interest rates are high.  

A few examples will provide a detailed analysis with specific data.

General Electric’s Warning Signs Before the Cut

For instance, conglomerate General Electric (GE) displayed several warning signs before its dividend cut in 2018. In 2017, the company’s payout ratio surged to an alarming 156%, which far exceeded the sustainable threshold. 

The company’s financial troubles were compounded by high levels of debt and a series of business challenges, such as the decline in loan book quality of GE Financial and a steady decline in manufacturing revenues. In response to these financial strains, GE dramatically cut its dividend from $0.24 per share to just $0.01 per share in 2018, a significant reduction that reflected the company’s dire need to conserve cash.

BP’s Payout Ratio Soared

Another example is the British multinational oil and gas company BP PLC (BP), which dramatically cut its dividends in 2020. BP’s scenario was a mix of sector-specific issues and financial stresses. Leading up to the dividend cut, BP’s payout ratio in the first quarter of 2020 was notably high at around 206%.

Furthermore, plummeting oil prices and the global downturn exacerbated by the COVID-19 pandemic severely impacted BP’s revenue streams. Consequently, in August 2020, BP halved its dividend from 10.5 cents per share to 5.25 cents per share, marking its first dividend cut since the Deepwater Horizon crisis a decade earlier. 

Effective Strategies to Avoiding Dividend Cuts by Stocks

 For investors to sidestep dividend-cutting stocks, the potential impact from the fallout, and ultimately build a robust dividend portfolio, they need to employ a blend of diversification techniques and diligent research. Importantly, avoiding all dividend cuts is probably an impossible task but the goal is minimizing the number and impact.

Diversification

You need to spread investments across various sectors and industries so that you can mitigate the risk associated with any single sector facing economic challenges. Diversification ensures that even if some stocks cut dividends, others in different sectors may remain stable or even increase their payouts.

Thorough Research

Furthermore, you need to conduct thorough research and due diligence at each company. You should not only look at current yields but also delve into a company’s dividend history, seeking out those with a consistent record of maintaining or increasing dividends. It’s important to understand the company’s long-term financial health by understanding if its earnings are growing, its debt levels are manageable, and its cash flows are robust.

Regular Reviews 

Finally, a resilient investment strategy involves regular reviews and staying informed about the current market trends and future economic forecasts. People must make adjustments as needed so that your portfolio remains aligned with your financial goals and risk tolerance.   

Conclusion on Assessing Dividend Stability and Avoiding Cuts

Investors need to employ key strategies to monitor companies that could potentially cut dividends. These include analyzing financial indicators like payout ratios, debt levels, and cash flow. 

They should look beyond surface-level metrics, delving into a company’s long-term dividend history and overall financial health. Diversification across various sectors forms a cornerstone of a resilient dividend portfolio, reducing dependency on any single stock or industry. Regular portfolio reviews and staying abreast of market trends and sector-specific risks are essential.We hope this article will be useful for you to assess the risk behind your dividend investments.

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