What to do when companies cut dividends  

The recent news about stock dividends seems grim.

In 2008, a record 62 companies in the Standard & Poor’s 500 index cut their dividends, amounting to nearly $41 billion in lost payouts. Another $30 billion of S&P 500 dividend reductions occurred in just the first two months of 2009, more than the preceding quarter’s record-breaking total, the S&P says.

With more industry giants slashing dividends, are dividends still a smart source of income for conservative investors? What does it mean when a company cuts or eliminates its dividend? Is there any way to predict the sustainability of dividends from your particular stocks? And where can investors turn for comparable, reliable income if their dividends are trimmed?

No easy solutions

“A dividend reduction is usually a flag for investors to do a bit more (research),” says Richard Hisey, president of AARP Financial in Tewksbury, Mass. “Just because somebody cuts the dividend, (it) doesn’t automatically draw you to one conclusion or another. The reduction could be a sign of danger or a very prudent move.”

Dividends are a company’s way of sharing profits with shareholders. Some companies have big dividends because they have extra cash to pass along. Other companies have small or no dividends because they don’t have extra cash or need to keep all the cash they can to grow the business.

“It’s not wise to use current dividends as a guide to the company’s financial health,” says Joseph J. Virostek Jr., vice president of investment operations at BPU Investment Management in Pittsburgh.

When companies reduce dividends, it merely represents a change in fiscal policy. They suddenly need to hold on to capital. It’s worth asking why, Hisey says. He says other possible reasons include:

• They’re investing more in building plants, developing new products or acquiring competitors.
• They’re facing extraordinary expenses, perhaps from having borrowed too much.
• They’re struggling with declining earnings and/or a plunging stock price.

What to do when your dividends are slashed

If a company trims its dividend, here’s the first thing you should do: Look at the press release that announced the reduction. It’s normally posted on the Internet. If you can’t find it, your broker or the company’s investor relations office should be able to supply it.

Try to understand exactly why the cut was made. Does management explain the reasons in a way that makes sense? Does it have cash problems, and are they long-term or temporary?

Second, examine the company’s balance sheet and quarterly earnings and cash-flow filings. They, too, can be found online or by calling your broker or investor relations. On the Internet, you can go to Yahoo’s finance site, type in the company’s stock symbol and click on “Key Statistics.”

You also can go to the corporate filings page of the U.S. Securities and Exchange Commission Web site.

In either location, you need to assess the level of debt versus the cash on hand. If long-term debt is less than half the capital, that’s generally good, says Scott Schluederberg, who manages the diversified high-yield dividend portfolio at Hardesty Capital Management in Baltimore. If it’s not, the company may be in danger.

“If a company is highly leveraged and then suffers an economic slowdown in which earnings are impacted, it’s going to have to use too much of its meager earnings just keeping up with the debt payments, and that will squeeze out the dividend,” he says.

Consider other possible causes for dividend reductions. The financial sector, for instance, has been unusually hard hit by dividend pullbacks. This is largely because institutions that receive federal bailouts are required to use the extra funds for lending while reining in dividend and other payouts.

Predicting cuts before they happen

Another important consideration is whether the company has a sustainable business model or one with a strong recurring revenue stream that’s relatively recession-proof.  Schluederberg prefers companies that offer services that people need rather than those that require “big-ticket, discretionary purchases which most consumers can put off.”

Sophisticated investors can further look into analysts’ earnings expectations. Even if you can find them, opinions may vary widely.

If possible, try to get a sense of not just its present net income to determine if the company can pay its next dividend, but its anticipated future earnings, an indicator of the sustainability of dividend payments going forward, says Jonas Elmerraji, a portfolio manager in Hagerstown, Md., and editor of The Rhino Stock Report.

Not that such diligent research is always necessary. In many cases, dividend reductions can be easy to predict.

“A dividend cut usually doesn’t come out of the blue but as the last in a sequence of bad news,” says Walt J. Woerheide, the Frank M. Engle Distinguished Chair in Economic Security Research at the American College in Bryn Mawr, Pa. “If you read in the news that your company just reported losing $2 billion, you can expect it to trim or eliminate dividends very soon.”

Woerheide urges investors to be aware of two rules of thumb about dividend distributions:

1. Dividends are almost always paid on a set schedule. If a payout is late, it’s a signal of a potential problem.

2. Most dividend-paying companies increase their payouts once a year and usually at the same time each year. If that date passes and the dividend doesn’t grow as much as usual, that may signal a cut.

Keep a sense of perspective

Be careful not to lose perspective. The number of companies that pay dividends has actually been shrinking for decades, says Yixin Liu, assistant professor of finance at the University of New Hampshire. Back in 1980, 64 percent of U.S. public companies offered dividends, but 25 years later only 41 percent did, she says. That might sound bad, yet the total dollar amount of dividends has been rising.

“The headlines make it sound like everybody is cutting dividends, but that’s not the case,” stresses Roger Young, an analyst and portfolio manager at Miller/Howard Investments in Woodstock, N.Y.

Indeed, while 485 U.S. companies slashed their dividends last year, 1,744 raised theirs, according to Capital IQ, a division of Standard & Poor’s.

Don’t dump equities

It’s better to look for those dividend-paying stocks rather than switch to other asset classes such as bonds or money-market funds or abandon equities altogether.

“People who are in bonds or cash instruments may feel smug because their principal is holding up while stocks collapse, but that’s going to backfire when the market recovers,” says Bill Staton, author of “Double Your Money in America’s Finest Companies.”

There are good reasons not to abandon stocks: It’s a bad time to sell stocks now that they have lost so much value. And when the market recovers, you don’t want to miss out, Staton says.

What’s more, the pursuit of dividends is still a sound investment strategy. In fact, it’s arguably wiser now than ever.

“In a flat or declining market, dividend income is a way to generate returns that are difficult to capture from capital gains alone,” says Thomas Forsha, a vice president at River Road Asset Management in Louisville, Ky., and co-manager of the $63 million Aston/River Road Dividend All-Cap Value Fund.

Over the long term, dividends can have tremendous power. “If $10,000 were invested in the S&P 500 in 1972, today it would be worth $208,972 if all dividends were reinvested, and only $74,547 if dividends were not reinvested,” says David Grenier, president of Cutler Capital Management in Worcester, Mass.

Even so, you can’t always count on companies that have maintained or increased dividends not to change course.

Management knows that positive dividend announcements are just as likely to attract investors and raise the stock price as negative ones are to do the opposite. So it’s always a good idea to take a closer look at the financial information, says Mary Harris, associate professor of business administration at Cabrini College in Rednor, Pa.

“Companies that hold their dividends stable or increase them are sending a message that they are in a strong cash position,” she says. “However, it’s not a definite sign.”

Taking the long view

More dividend cuts are likely, given the ongoing credit crunch. Companies are having hard time borrowing money, and holding onto their money improves their creditworthiness. They can’t do a secondary offering of stock at current valuations. So they have no place to go except their shareholders.

“From the company’s viewpoint, cutting the dividend is prudent cash management,” Peter Miralles, an adviser at Atlanta Wealth Consultants, a financial management firm, says.