Why dividend cuts can be toxic for your portfolio

Dividend cuts stock price reaction

As a dividend investor, the aim is generally to invest in companies that pay increasing dividends year after year. This is a proven way to generate long-term wealth, as not only will an increasing dividend stream enable you to take advantage of the power of compounding, but the rising dividends should lead to rising share prices over time as well.

In contrast, what every dividend investor wants to avoid at all costs – is dividend cuts.

Here’s a look at the share price performances of several companies that have cut their dividends in recent years.

Tesco

Tesco (LON: TSCO) (TSCO.L) was once considered a core holding for UK dividend investors. The company had a fantastic record of dividend increases, and raised its dividend for 27 consecutive years up to 2011.

However, on 29th August 2014, Tesco announced that it would be cutting its dividend by 75%, reducing its first-half dividend for 2015 to 1.16p per share, down from 4.63p the year before.

We can see from the chart below, that the stock had been trending downwards well before the dividend cut. Profitability was declining, and investors were clearly sceptical about the financial health of the company. The stock fell further upon news of the dividend cut and has struggled to regain ground ever since. Those investors who bought the stock above 350p, would now be sitting on a capital loss of around 50%.

Barclays

Barclays (LON: BARC) (BARC.L) announced on 1st March 2016 that it would be cutting its dividend by over half, from 6.5p in FY2015, to 3.0p for FY2016.

While Barclays fell 8% on the news, the damage had already been done, with the stock trending down from around 290p to 170p in the seven months before the cut was announced. The share price has recovered to a degree, but is still well below where it was in early 2015.

Provident Financial

More recently, just last week Neil Woodford favourite Provident Financial (LON: PFG) (PFG.L) announced that it would be scrapping its interim dividend and that it would most likely be unable to pay a full-year dividend.

To say Provident has been punished is an understatement, as the shares fell over 70% on the day of the announcement. Given that the stock was trading above 3,200p back in May, this is a dramatic decline.

Moral of the story

The lessons here?

Dividend cuts can be toxic for your portfolio, because you’re likely to lose both the dividend income and also see significant share price declines.

Often, the damage has already been done to the share price before a company cuts its dividend. The smart money has exited the stock, pushing the yield up to levels that look dangerously high. It’s important to remember the old adage that “if it looks too good to be true, it probably is.”

When investing for dividends, it’s important to always look into the sustainability of a company’s dividend. Look at factors such as:

  • Revenue and earnings trends
  • Recent dividend growth rates
  • Whether earnings sufficiently cover the dividend payments
  • Whether cash flow sufficiently covers the dividend payments

By spending a little bit of time investigating the sustainability of a company’s dividend, you should be able to minimise the chances of investing in a company that cuts its dividend, and as a result, your portfolio should prosper.

Disclosure: Edward Sheldon, CFA has no position in any shares mentioned. 

This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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