Dividend Cuts: Before, During, and After

I was reviewing some of the high-profile dividend cuts in the past five years–Pitney Bowes, Conoco Phillips, BHP Billiton, Viacom, Wells Fargo, General Electric, Dow Chemical, American Express, U.S. Bancorp–and I was trying to figure out if there were some elements regarding investor sentiment that could aid us in drafting some common rules relating to the experience.

Here is what I found:

In the nine months preceding a dividend cut, these stocks saw their earnings decline by an average of 62.3%.

And yet, in the nine months preceding a dividend cut, these stocks only saw their stock price decline by an average of 31.0%.

When the dividend cut came, these stocks experienced a maximum trough of an additional 38.5% decline on average (in other words, I measured the subsequent lowest price that occurred sometime within the year after the dividend cut and compared it to the price that existed on the day before the dividend cut.) However, of those stocks that have experienced at least three years since the time of their dividend cut, the subsequent performance has been almost 18% annually since the day of the dividend cut announcement.

The lesson involving investor sentiment re: dividend cuts seems to be that investors ignore, disregard, and/or underweigh the negatives that accumulate in the quarters leading up to the dividend cut. Earnings fall, but the stock price doesn’t fall as much because it doesn’t feel as real when the tangible dividend check keeps rolling in.

Then, the day of the dividend cut arrives, and this serves as the moment when investors not only fully incorporate all of the past reality, but overreact and punish the stock more than it deserves. This creates a deep value price point, and then a subsequent mixture of improved business performance mixed with P/E expansion leads to outperformance in the years that follow.

The announcement of a dividend cut has a weird mirroring effect. Typically, investors realize that they have been under-weighing past negative events that had an impact on earnings, and then overreact to reality thereafter by punishing the stock more than is deserved.

This also shows why market timing is so difficult. To mitigate losses, you really need to see the dividend cut coming almost ahead of time. By the time a dividend cut is evident, and when it finally happens, the general investor sentiment moves toward panic and the stock gets unfairly punished. This is the moment of maximum pain, but it also the moment when the seeds of future outperformance have been sown.

The chronology for a stock facing a dividend cut is that people under-weigh the deterioration that precedes it, then overreact once the dividend cut becomes palpable, and then the stock outperforms thereafter as investor sentiment finally pivots towards rationality. This sequence is why I criticize investment writers that suggest selling a stock as soon as there is a dividend cut. This is often the moment when the valuation is so low that the stock is primed for future outperformance.