(By David Brickell) Investors hate dividend cuts or suspensions and companies fear them. There are few actions that CEOs dread more than cutting dividends, which partly explains why they happen so infrequently. In his classic 1956 study on dividend policy, Lintner interviewed corporate managers and found: "a reluctance (common to all companies) to reduce regular rates once established and a consequent conservatism in raising regular rates".
More recently, a survey in 2005 of payout policies found that 78% of companies are reluctant to make dividend changes that might have to be reversed. As a result, dividends tend to follow a much smoother path than earnings - the variability from 1960 to 2008 of year-to-year changes in dividends was just 5.2%, compared to 14.7% for earnings!
Don't Frighten The Horses!
Given the typical volatility in corporate earnings and cash flows, it might seem surprising that dividends do not follow suit. Wouldn't it be rational for firms to actively reassess how much they should pay in dividends as their prospects change? Surely paying an unsustainable level of dividends is going to be worse for investors in the long term, especially if it leads to a dilutive capital raising.
Managers' reluctance to cut dividends is however understandable when you look at the typical investor response to a dividend cut. This is indiscriminate. Several studies show that investors just dump the stock - in 80% or more of cases, the stock prices of firms that cut dividends drops sharply, at the time of the announcement. Furthermore, research by Michaely, Thaler and Womack found that that stock prices then continue to drift downwards in the weeks after a dividend decrease. And this seems to happen no matter what the stated reasons for the dividend cut.
Can a Dividend cut ever be good?
Companies may cut or suspend dividends for several reasons; some clearly have negative implications for future prospects and the value of the firm, whereas others have more positive implications. It may be:
- A last ditch response to operating problems (declining earnings and losses), i.e. the company has finally run out of other options.
- A pre-emptive action to increase financial flexiblity and avoid future problems (e.g. by using the cash saved to retire debt).
- Alternatively, it could simply be because the firm wants to invest more than it expected (e.g. a dramatic improvement in its strategic options) which is actually good news for the long-term prospects of the firm.
A classic example of a "good news" dividend cut is Florida Power amp; Light in the US. In 1994, FPL cut dividends by a significant amount (32%). It was the first cut by the company in 47 years and the decision was taken in the midst of uncertainty due to deregulation in the electric utilities industry. Far from financial distress, FPL announced, at the same time as it cut dividends, that it was buying back 10 million shares over the next three years and emphasized that dividends would be linked more directly to earnings. As expected, investor reaction to FPL's cut was negative but analyst reactions were more mixed.
So what happened? On the day of the announcement, the stock price dropped 14% but recovered this amount in the month after the announcement and earned a return of 23.8% in the year after, significantly more than the Samp;P 500 over the period (11.2%) and other utilities (14.2%).
Clues to Watch Out For...
How then can investors tell when a dividend cut is good news? There's a good piece of research by Bulan, Subramanian and Talun which considers this question. They found that firms that confront and deal with dividend problems early on see their stock prices recover much more quickly than firms that allow the pain to linger and misuse the cash from dividend cuts.
They looked at 445 dividend suspensions/omissions from 1962- 2001 and found that that nearly 35 % of them fell into the "good" category. These cuts were followed by a significant improvement in operating performance and in many cases, a resumption in dividend payments within the next five years.
Their work found, unsurprisingly, that a key determinant of whether an omission was good or bad was the company's fundamental performance at the time of omission. "Good firms" had higher profitability, better financial flexibility (lower debt overhang) and took active steps to reduce their debt overhang around the time of the omission - while bad cutters had persistent debt overhang and lower ROA. As they put:
"Good omitters move away from the "brink" after the omission, while bad omitters continue to be financially constrained even after the omission".
In subsequent work, Bulan has also found that the stock marker over-reaction was likely to be most severe where there was a high degree of surprise and less visible signs of poor performance, i.e. the markets actually get it most wrong for the "good omitters".
In a similar vein, work by Woolridge and Ghosh looked at 408 companies that cut dividends, identifying three groups. The first group announced an earnings decline or loss with the dividend cut (176 companies); the second had made a prior such announcement (208); and the third made a simultaneous announcement of growth opportunities or higher earnings (just 16). Again, they found that the market seemed to react negatively to all of them initially, but the negative reaction to the dividend cut seemed to persist in the case of the firms with the earnings declines, whereas it was reversed in the case of the firms with better investment opportunities.
A dividend cut may not always be a sell...
The level of scepticism shown by investors towards claims by companies of increased investment requirements at the time of a dividend cut is understandable, especially if the firm also reports lower earnings and has a history of poor project returns. However, the data suggests that the market tends to be overly-sceptical. As you will probably know, we love signs of market inefficiency or herd behaviour - that's when we usually reach for the Screener. We're still considering the best way to screen for this apparent inefficiency, perhaps something along the lines:
- Recent Dividend Cut
- High degree of Negative Dividend Surprise vs. Analyst forecast BUT
- Strong Operating Cashflow
- Low Levels of Accrual
- High amp; Consistent ROA
- Low Leverage
We've not seen any back-testing of this strategy yet, though, so perhaps not one to try at home just now!
More generally, there's a lesson that, if you're still a shareholder in a company which decides to scrap its dividend, it may not make sense to dump the stock straightaway. Each individual case should be taken on its own merits. There looks to be value to examining closely timed earnings and dividend cut announcements to see if the market reaction is justified.
While sometimes the cancelled payout is a sign that the company is toast, in other cases, the action may be in the shareholders' long-term interests. A company may be taking prudent measures to conserve cash in tough times or it could be a wise decision to divert cash to exciting new projects.
Dare we say it, it might even be time to be taking advantage of the market over-reaction and buying more shares!