Should I sell if a stock cuts its dividend?

Dividend strategies are popular amongst UK investors. The ability to receive a market-beating passive income from simply holding large, steady companies is incredibly attractive to those who use their stock portfolio to help with living expenses. There is evidence that this kind of Value strategy beats the market over the very long term, although perhaps by less than other value strategies.

Towards the end of 2022, I wrote an article proposing a Value-first strategy. I suggested investors would be better off screening for stocks that meet Value criteria first and then picking a diversified collection of the highest-yielding stocks out of these. However, when I reviewed this strategy in 2023, the results were a little disappointing. What I called the “Safer Income Portfolio” beat some other simple value strategies. However, it underperformed the FTSE All Share, at least on price-performance:

More disappointingly, the portfolio contained four companies that cancelled their dividend payout:

And some that cut their dividend while not completely cancelling it:

It seems that this income portfolio was not safe enough, and in my mea culpa, I concluded that:

…the riskiest holdings have done the real damage. These stocks clearly had significant political risks when the portfolio was formed...It can be tempting to “juice” the income portfolio with high-yielding but risky or under-diversified stocks. With the benefit of hindsight, I would have picked much more stable businesses from these industry sectors.

However, fast forward another year, the “Safer Income Portfolio” has recovered its underperformance:

Although the dividend cuts hurt the income, it still delivered a 4.8% TTM dividend yield, meaning that the two-year performance of the strategy appears to have slightly outperformed the wider market on a Total Return basis. This is despite a few more shares joining the dividend cutters, such as EKF Diagnostics Holdings (LON:EKF) , Spirent Communications (LON:SPT) and Headlam (LON:HEAD) .

This leads to an interesting question:

Should I sell if an income stock cuts or cancels its dividend?

Many income strategies simply sell if a dividend is cancelled and reinvest the proceeds elsewhere. The logic seems sound. If investors are relying on that income and are no longer getting it, then they should move their capital to where they are receiving sufficient dividends. In addition, a complete dividend cancellation is often a last resort by company management and suggests that the business is experiencing very significant headwinds in trading. The research Ed and the Stockopedia team have done into profit warnings suggests that it takes much longer than investors think to turn around a struggling business and that investors are better off selling on the first warning:

Selling on a divided cut may appear logical.  However, financial markets have a habit of defying conventional wisdom. The reason is that secondary effects come into play. When many investors own a stock for its high dividend yield, a dividend cancellation will cause a rush for the door. If income funds own it, they may become forced sellers of the shares as their mandate will not allow them to own non-dividend-payers. In this case, it may be that such stocks become quickly oversold. Investors may be better off holding on, or even buying after a dividend cancellation.

So which is it? Is it a sign of corporate weakness that warns of further pain, or is it an opportunity to take advantage of? This is the question I hope to answer.

What does the data say?

Finding a list of dividend cancellations can be difficult. Thankfully, Alex has been able to use the Stockopedia archives to find over 700 stocks that cut, suspended or cancelled their dividend since March 2020. Here is what the average price chart looks like leading up to a negative dividend surprise:

A couple of things stand out from this chart. The first is that the price tends to be weak in the run-up to the dividend surprise. The second is that it recovers quite quickly. On the surface, it would seem that investors should buy following dividend cancellation or cut. However, 475 of these negative dividend surprises occurred in 2020, and for obvious reasons – COVID created huge uncertainty for most companies, and they responded by hoarding capital. If we exclude 2020 from the data, we get a very different picture:

While the biggest drop occurs on the day of the announcement, it seems that the market often anticipates the cut up to three months prior to its occurrence. It seems that investors should be selling at the first sign of news that has the potential to leave a company unable to maintain its dividend rather than waiting for confirmation that the payout has been axed. When building an income portfolio, investors should look for safety above all else. The problem is that this may be a difficult strategy to implement. Investing in high-yield stocks is, by nature, acting countercyclically. The high yield is often a sign that the market doesn’t like the prospects for a stock, and the price has declined. It is far rarer that an already high dividend payout has been increased rapidly with a static share price. Accepting a lower yield but choosing stocks that are growing their dividends may avoid the pain of dividend cuts. However, the so-called dividend growth strategy is an even poorer option. All the evidence points towards it underperforming by simply buying already high-yielding stocks. There are perhaps no easy answers to this dilemma, and investors will need to assess each situation individually when building an income portfolio.

If an investor has failed to anticipate a dividend cut, then they will usually face a painful paper loss. The data above suggests that far from being an overreaction, there is likely to be further pain to come over the next year. Investors would be better off crystalising that loss and moving on to pastures new, especially if they are reliant on the income. The good news is they typically have a month or so to act before further bad news tends to arrive and be priced in.

However, this is not the whole story. I asked Alex to split the data further. Firstly, by looking at the average performance of the stocks that suspended or cancelled their dividend versus those that merely reduced it. Here is the data, excluding 2020:

This confirms my second hypothesis: that investors overreact to a dividend cancellation or suspension. While the reaction in the run-up to, and on, the day that bad news about the dividend is released, stocks that merely cut their dividend did much better. However, over the subsequent year, these stocks underperformed the market, on average. Conversely, the complete removal of the dividend is understandably treated much more harshly, but this point tends to reflect a nadir for the share price. Over the following year, there seems to be the possibility of between 5-15% outperformance from holding stocks from the point of cancellation.

The second nuance that I wanted to investigate was if higher-yielding stocks at the point of cut or cancellation behaved differently lower yielders.  This could be caused by income funds being forced sellers of formerly high-yield stocks, for example. Here is the high-yield versus low-yield comparison, which I picked as a nominal 4% historical yield at the point of negative surprise:

This shows that higher-yielding stocks both anticipated the cut and reacted more severely, but over the following year, they ended up with a similar performance. The performance of the high-yielders is not strong enough to suggest that these should be bought following a dividend cut. However, it seems clear in this data that investors should take the hit and sell lower-yielding stocks that reduce their dividend payout.

The 2020 data is also instructive as well. While investors are better off reacting to idiosyncratic dividend cuts by selling, the same doesn’t apply when large-scale macro events are the cause of negative dividend surprises. During pandemics, financial crises or other widespread sell-offs, the dividend cut is far more likely to be the nadir of the share price:

During such times, investors should follow the opposite strategy and hold or even add to stocks that cut their dividends. It seems that the more severe the cut, the bigger the bounce (although the pain of holding prior to an adverse dividend event is also much higher.)

Conclusion

Investors will do better, on average, by selling stocks that cut but don’t cancel their dividends, especially if they are already low-yielders. Cutting a dividend appears to be a sign of further bad news to come. The only exception is if it happens at a time of crisis, such as in 2020, when many stocks are reducing their payouts. Here, a share price recovery is more likely.

The opposite course of action seems best for stocks that completely remove their payout by cancelling or suspending dividends. While investors in these stocks will have suffered significant pain, the sell-off tends to have already occurred. The market both anticipates the cut and reacts quickly on the day of the bad news. Avoiding these types of stocks is hard, particularly for income investors, but the severity of the reaction makes it worth trying. However, at the point of dividend cancellation, the market appears to have overreacted and holding for a recovery makes more sense. A brave but potentially profitable strategy could be to buy stocks shortly after a dividend cancellation to gain exposure to the recovery.