What sounds crazy at first sight, indeed is rather an interesting strategy to think about. Sounds crazy, as almost everyone is talking about higher dividends? Let me make the case for dividend cuts! My next stock idea from my upcoming research report fits exactly into this scheme.
Summary and key takeaways from today’s Weekly
– Dividend cuts can be a sign of financial discipline.
– Despite what most investors believe, a dividend cut can actually make some (!) companies more valuable if the underlying case is sound.
– It’s key to distinguish between value traps and turnaround candidates. The rewards can be handsome.
It is almost safe to say that I will (again) anger one or the other dividend-bro with this article. 🙂
As I think that there’s some valuable information to be extracted and put into one’s investment strategy, I don’t care. What I care about is getting new, at times surprising insights. Today’s topic is such a case as it might be surprising that it’s not uncommon for companies which have cut their dividend to do well afterwards – under certain circumstances.
Actually, not only operationally, but also regarding the stock.
In fact, many dividend cutters are good enough not only for a small rebound as the bad news are often already priced in, but even for market beating returns!
Dividend cutters and market beating returns?
There are certain patterns that could have been observed in the past. Paired with some logic and common business sense, indeed there are good arguments for, not against dividend cuts.
First and foremost, the underlying business must be relatively stable.
Stability and at least some sort of predictability in the underlying business are great starting points. If you add to that strong free cash flows or at least a realistic prospect or catalyst for the cutter to start generating healthy free cash flows, often paired with strong deleveraging of the balance sheet, you’re halfway there.
Another point is a beaten-down valuation where more negative than positive things are priced into the stock. You will also often observe that prior to the dividend cut the suspect’s stock has been falling for a while until news hit the headlines.
The cut then can be the long awaited turning point as the hot air is finally let out.
Otherwise, distributing a dividend the company actually cannot afford to pay due to weak operating results and not sufficient enough free cash flows and / or too high debt, will only be a short-lived pleasure.
That’s why looking for dividend cutters – and strictly selecting – can be a viable method of spotting future outperformers. As I have so far only written articles about upcoming dividend cutting candidates and stopped there, I want to expand on this today.
The result is a new stock idea which I am featuring in my upcoming next member-exclusive research report (due next Saturday, 16 March 2024).
The average total return of my active best stock ideas is +19.5%, beating the S&P500 and the iShares MSCI World ETF.
as per 13 March 2024 market close – since August 2022
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Cutting off the shackles to be free again
Dividends without a doubt offer several benefits to companies and shareholders alike, and as a fact, dividend-paying companies tend to outperform over the long-term.
Who doesn’t know charts like the one below?
I have shown it in my article here that dividend paying companies which ideally even grow their distributions, over the long-term outperform their non-paying peers. Those without a clear dividend strategy or infrequent payments (or without raising the dividend at all), tend to do at least better than non-payers or cutters and eliminators.
When thinking about today’s multi-bagger tech stocks with small dividend yields or even none at all, this could be questioned, though in the past it worked.
A few tech companies like Meta (ISIN: US30303M1027, Ticker: META) or Booking Holdings (ISIN: US09857L1089, Ticker: BKNG) in the meantime even initiated their first dividends.
But taken as groups, this was the trend. Numbers don’t lie.
You will laugh, but dividend cutters and eliminators are ranked the lowest.
So how did I come up with the idea of searching for dividend cutters? My answer:
A dividend cut can have a liberating effect, marking the bottom of bad news and sending the stock higher again.
One of the reasons is that companies that pay dividends need to be financially stable and to generate sufficient amounts of free cash flow to be able to pay dividends to begin with.
If financial stability is not given, because management has taken on too much debt like it was the case with many companies over the last decades of falling and then ultra-low interest rates, the decision makers can be forced to do something the group of dividend collectors does not like – cutting their precious income stream.
But this is not limited to just indebted balance sheets. Also decreasing revenues and cash flows below the payout or a need for huge investments can be valid reasons for a course correction.
As especially in the US there is a tradition of serial and uninterrupted dividend payments and also raises, the decision to axe a distribution is tougher than for example in Germany where dividend aristocrats are a foreign term simply because such a tradition does not exist.
Dividend payers and those that frequently increase their payouts create an aura of expectation to deliver, though a dividend does not necessarily increase the value of a company. But there’s no denying that reliable dividend payers are often bought exactly for that reason: their reliable income streams.
Sometimes a dividend cut can be a wise decision that increases a company’s value.
How so?
A dividend is a cash outflow. Cash that leaves the company decreases its value. So if you keep the cash instead and do something more favorable, then the company’s value can be increased.
Such value increasing measures can be paying off debt, investing in the business at returns that are higher than the cost of capital or also repurchase own shares at the open market at cheap valuations.
Personally, though I am not against high yielding dividend stocks when the payouts are sustainable, especially at low valuations I clearly prefer stock repurchases or growth investments. I view dividends as a luxury problem and only appropriate when the company cannot do anything useful with the capital.
Only then should excess cash be returned to shareholders.
While the majority likely thinks that dividend cuts are a negative indicator and a sign of financial issues, it can also be a prudent decision to reallocate capital where it is needed most.
A dividend cut does not have to be against shareholder’s best interests, but indeed can even be in line with them.
The investment bank Morgan Stanley from time to time publishes a research paper where they are exactly reviewing this: dividend cuts and the performance of the affected stocks after the event. In 2008, 2016 and also now in 2024 they released a paper with interesting insights.
On the surface and in the short-term, a dividend cut is seen negatively by the market.
But watch now what the studies of MS have found out: dividend cutters can offer value. Not only a little, but sometimes even good enough to beat the markets.
In this case, they analyzed British stocks that cut their dividends and compared them to the MSCI UK Index.
The bottom line here is that companies which instead of stretching their balance sheets too far, instead go for the painful move, sooner than later are rewarded with a strong stock performance.
You can see above that the underperformance came before the looming dividend cut.
The cutters even outperformed the markets and their sectors and the effects are even better the higher the dividend cut, because a) the uncertainty is gone and b) lots of capital is freed up. After the dividend seekers sell and not seldom force a final wash-out, a strong turnaround sets in.
When certain things are considered.
When a company cuts its dividend, it’s necessary to understand the greater context and to decide if it’s a value trap or a buying opportunity.
The company must not be dying immediately or facing huge incalculable risks.
Enough theory, let’s look at some real-world examples.
Take the case of Bayer (ISIN: DE000BAY0017, Ticker: BAYN) which finally a few weeks ago cut its dividend to the required minimum of 0.11 EUR from more than 2 EUR before. However, the cure didn’t help as the underlying root causes are not gone and the freed up capital is only a drop in the ocean of the issues. The debt load is too high and also its legal problems are by no means gone.
Value trap!
Another example for not having worked out is V.F. Corp (ISIN: US9182041080, Ticker: VFC).
The former dividend king even with 50 consecutive raises did overstretch its finances only to keep up its series. Last year, it even had to cut the dividend twice.
It didn’t help as the stock has fallen further and not really taken notice.
The company has massive debt and growth issues. There is nothing that hints into the direction of a successful turnaround. Value trap!
A different case is Intel (ISIN: US4581401001, Ticker: INTC) which I in advance wrote that their dividend will be cut, but I did not buy it then. I am still not so convinced like the market seems about the coming success of this ongoing turnaround.
Investments are huge and free cash flows are currently non-existent. Too risky for me.
Anyway, first there was the cut to put the freed up capital to work. Though not a perfect example, you see that the stock well in advance declined and after the cut was already on its way back up again.
The case of tobacco company Imperial Brands (ISIN: GB0004544929, Ticker: IMB) was more the type of situation I am out for – though I didn’t participate here either.
Also due to too much debt, the dividend had to be cut. But as you can see, after a long drop this almost marked the bottom. Though we likely won’t see a full-blown recovery to former glories in this dying market, the stock did advance considerably, almost doubling from trough to peak.
Imperial is not a growth stock, but until here it’s free cash flow generation was strong and freed up capital was used to delever the balance sheet. It has now among the best balance sheets in its sector and it is aggressively repurchasing stock.
I think that dividend cuts would rather be favorable for some of its peers, too, even though the first reaction might be negative. But this could be a buying opportunity.
A successful turnaround was the case of goo’ old General Electric (ISIN: US3696043013, Ticker: GE) which also cut its dividend to then undergo a reorganization.
Massive debt and an inefficient company structure made the once most valuable company more than twenty years ago only a shadow of its former self.
However, with the new CEO starting in 2018, an almost unbelievable turnaround was achieved. In total about a 100 bn. USD in debt were repaid and refinanced and the company is leaner and fitter. It is currently spinning off its energy division after the healthcare unit was already separated.
The core will remain the aviation business.
But you see, the dividend cut to only a penny per quarter marked almost the bottom. From the bottom until today, the stock surged by more than 4x and it does not look like it’s finished, though it is certainly not cheap anymore.
Despite what certain investors believe: a dividend cut can actually make certain companies more valuable and great investments.
In essence, a dividend cut can be even beneficial as long as the reason behind it is sound the same as the whole situation is “under control”.
The most important thing to understand about dividend cuts is the underlying context that led to the decision. By digging deeper, one can find out and assess the further risks.
This led me to an interesting story of a company where I think that it could follow in the footsteps of GE. It also cut its dividend to retain capital. After many issues and also a collapsing stock, there’s a good chance that the bottom might be in, because it is repaying its debt and free cash flow is about to go up significantly, not to mention that the stock is trading way below the company asset’s value.
Conclusion
Dividend cuts can be a sign of financial discipline.
Despite what most investors believe, a dividend cut can actually make some (!) companies more valuable if the underlying case is sound.
It’s key to distinguish between value traps and turnaround candidates. The rewards can be handsome.
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