When Dividends Turn Dangerous

John D. Rockefeller once said: ‘Do you know the only thing that gives me pleasure? It's to see my dividends coming in.’ Presumably, nothing ruined Rockefeller’s day like a dividend cut. For modern day investors, the threat of a dividend cut can be just as unsettling, especially if the cut is symptomatic of deeper financial troubles.

But only in very rare cases do dividend cuts come out of the blue. By evaluating share price trends and key financial metrics, investors can minimise the risk of dividend disruptions. Over the past few weeks, we analysed over 700 dividend cuts that have occurred since the beginning of 2020. Our review included:

• Companies that canceled a specific payment.
• Companies that suspended payments indefinitely.
• Dividends where the cash payout had declined on a year-on-year basis.
• Dividends where the payout was lower than initially promised.

Our goal was to identify red flags that appear before a dividend cut, helping investors align with the base-rates and minimise portfolio risk.

Trust the crowd

Many investors, including Warren Buffet, take a contrarian approach, insisting that investors should be fearful when others are greedy and greedy when others are fearful. The problem is that this mantra may not work all the time. Last week, my colleague Mark showed that the price tends to fall before the dividend is actually cut, as if the market has a collective crystal ball. It could be that the market knows something we don’t. This is perhaps why we should trust the wisdom of crowds…

According to the ‘wisdom of crowds’ theory, the collective knowledge of a large, diverse group is better at making decisions than the knowledge of any single individual. There are a few caveats: the theory assumes that the group is diverse, and that individuals in the group are not influenced by others. This theory is very applicable to the stock market. It nicely compliments the efficient market hypothesis, which argues that share prices reflect all available information about a given stock. Both theories emphasise the power of collective knowledge.

The stock market is made up of investors (i.e., the ‘crowd’). They often make independent decisions using their own information. In turn, the collective action of all these investors lead to stock prices that accurately reflect all available information. Can this collective knowledge foresee a dividend cut? Yes, quite possibly. In the run-up to a dividend cut, investors have access to market data which can suggest a dividend is at risk. Let’s look at a few examples:

• DFS Furniture announced its dividend cut on 25 September 2024, explaining that the ‘market backdrop’ was ‘significantly more challenging than we expected.’ This news did not come out of the blue. An earlier trading statement on 12 June noted that trading conditions had ‘remained challenging’ and shipping issues ‘have persisted resulting in delays to customer deliveries and higher freight costs.’
• Ferrexpo announced on 20 February that ‘the Board of Directors has decided not to proceed with the Company's proposed interim dividend’. The group explained: ‘The decision to withdraw the Interim Dividend follows subsequent and unexpected events in Ukraine relating to a claim against one of the Group's Ukrainian subsidiaries’. Again, this news did not come out of the blue. Political risk in Ukraine was apparent well before February 2024.

Perhaps we should take Buffet’s advise with a pinch of salt. Various factors cause the share price to decile even before the cut is announced. This is often reflected in a company’s MomentumRank, which assigns a higher rank to companies with stronger price momentum. Investors can therefore guard against dividend cuts by honing in on high momentum stocks. This method is employed by the US-based Russell Research as a component of its Russell High Dividend Yield Index Series. They exclude the bottom 10% of stocks ranked by 12-month price momentum.

If it looks too good to be true…

Movement over time can teach us much more than a single snapshot. The top bar chart above suggests that dividend cutters are likely to have a high ValueRank, but there is more nuance to it. More specifically, the ValueRank is high but rising…

What exactly drives this trend? It is often driven by price momentum. Downwards price movements can penalise the MomentumRank, but as the price goes down, a stock becomes cheaper in terms of valuation ratios like the P/E ratio and the P/S ratio — fields which all feed into the ValueRank. As a result, value and momentum often move in opposite directions. Many readers will know that this trend is inverse correlation.

A price drop also causes the Yield to increase. When a company is about to cut its dividend, the yield may actually appear attractive; the dividend yield is usually rising, and on the day of the cut, the company often has a higher yield than the market median.

Be cautious, though — high-yielding companies are a bit like the sirens from ancient Greek myths, luring investors in with false promise. And this raises a critical question: How can investors separate the wheat from the chaff? What metrics can help them distinguish between potential dividend traps and genuine dividend quality?

Separating the wheat from the chaff

The QualityRank is designed to identify profitable, cash generative, and financially stable companies — companies which are in theory ideal dividend payers, given that dividends are ultimately paid out of profits and cash.

At the same time, various studies have found that the best leading indicator of a dividend cut is fundamental momentum — i.e. the trend or change in profits and cashflow, rather than profits and cashflow at a single point in time. Fundamental momentum is only one component of the QualityRank. The rank also comprises long-term average ratios, which are more slow moving and may not be impacted by recent changes in a company’s financial position.

To analyse dividend safety, we should look at quality themes, like profitability and cashflows, but rather than look at the long-term average, we will look at recent fundamental trends.

Profitability

In the run-up to a dividend cut, we see a downwards shift in returns as well as margins.

A decline in profits and earnings is a bad sign. It translates into a lower Dividend Cover ratio. This datapoint measures a company's ability to pay dividends from earnings. It is a key dividend safety metric, calculated by dividing earnings by dividends. We can also use a cash based ratio — i.e. Free cashflow divided by dividends (FCF PS/DPS).

There are some rules-of-thumb:

• A cover above 2x is considered robust.
• A dividend cover below 1.5x might signal a potential risk of a dividend cut. This is arguably arbitrary, but it emphasises the importance of maintaining a margin of safety.

Before a dividend cut, the Dividend Cover trends downwards, as dividend growth outpaces earnings growth. If companies pay dividends without the requisite cash or earnings, investors face a situation where dividends are likely propped up by borrowing, asset sales, or dwindling reserves — all inherently unsustainable.

Financial Health

Investors hunting for dividend safety should also pay attention to financial health, with cash flow being a crucial factor. Companies need cash to meet financial obligations, including paying dividends and also servicing debt. In a company's capital structure, debt holders (creditors) are generally higher in the hierarchy than equity investors (shareholders). If companies are forced to choose between penalising investors and penalising creditors, investors may draw the short straw. Perhaps it is not surprising that dividends are cut when cash becomes tight and firms struggle to service debt.

The Altman-Z score is another useful ratio. It encompasses profitability, leverage, liquidity and solvency metrics and is essentially a ‘distant to default’ formula. We can see that the Altman-Z score declines in the run-up to a dividend cut, implying that the ‘distant to default’ becomes smaller.

Key takeaways

When building an income portfolio, investors should look for safety above all else

Last week, Mark Simpson showed that share prices plummet when companies cut their dividends. He said: ‘investors should be selling at the first sign of news that has the potential to leave a company unable to maintain its dividend’. He added: ‘When building an income portfolio, investors should look for safety above all else’. This week, we elaborated on what safety looks like. We examined the red flags around dividend danger so that investors can steer clear of risky dividend traps. The key takeaways were as follows:

• Dividend cutters often have deceptively high yields, usually above the market median;
• Dividend traps have weak price momentum, typically reflected in a low MomentumRank;
• Just before a company cuts its dividend, it usually has declining profitability, measured in profit margins and also returns on capital (ROE, ROA, ROCE);
• In the run-up to a dividend cut, a company will often have a weak Dividend Cover (measured using earnings and/or cashflow);
• The financial health of a company will be declining just before a cut, as can be seen from trends in the Altman-Z Score and the ratio of cashflow to debt.

By recognising these red flags, investors can better protect their portfolios from the financial fallout of dividend cuts. Prioritising safety and diligent analysis can help ensure a more stable and reliable income stream, even in uncertain markets.