How Safe Is The Dividend?
What happens when the market questions the dividend? Morgan Stanley looked at the price development both before and after dividend cuts to 372 European companies from 2005 to 2015. The median return 12 months before dividend cuts was 19% weaker than the market.
But after the news had been released and the uncertainty was gone, the price development was 11% better than the market in the following 12 months, and as much as 19% better in 24 months.
The probability of excess return in relation to the market after a dividend cut is 65% within 12 months and 66% for 24 months.
The survey shows that the more the stock fell before dividend cuts, the better the return after the news. The shares that had a dividend yield of more than 12% before it was cut had a full 83% probability of rising more than the market over the next 12 months.
The worst returns after a dividend cut were those that fell less than 20% relative to the market.
During the financial crisis in 2008/2009, almost 33% of the dividend shares in the S&P 500 slashed dividends, but the majority of these were financial shares.
On the Oslo Stock Exchange, many also cut dividends, some stopped dividends completely. You may ask if it is possible to predict which shares are at risk of cutting dividends.
Yes, it can be done to a certain extent, relatively simple and objective criteria can give a strong indication. Your goal as a dividend investor should be to buy stocks that pay rising dividends over time, and the survey by Morgan Stanley mentioned above shows that the market prices dividend cuts long before it actually happens.
To avoid dividend cuts, only invest in stocks that are solid, growing, and withstanding a recession.
The companies that cut dividends usually (or a combination) have too high a dividend in relation to earnings, weak cash flow, declining sales or profits, weak balance sheet / a lot of debt, cyclical earnings, and perhaps poor management.
By looking more closely at this, you can look much deeper at how the company in the future will generate cash to service the dividend.
There should be a correlation between profit and cash flow, and they should preferably be rising. The higher the cash flow in relation to turnover, the better.
Also, the closer the dividend ratio to 100% of free cash flow, the less sustainable the dividend is. Increasing the dividend payout ratio is a dangerous signal, especially if the dividend increases more than free cash flow. This is of course a bit dependent on the industry, but a rule of thumb is a maximum 70% payout ratio.