What Dividend Cuts Teach Us

As income investors, we rely on dividends to grow our portfolio thanks to the miracle of compounding. So, dividend cuts are the enemy of us income investors.

So far this year, announced dividend cuts exceed any single year totals since 2010.

What Happened?

In a nutshell, COVID-19 happened.

It’s literally the craziest thing that’s happened to us in my my lifetime – economically, financially, everything-ally.

Sure it’s easy to blame the companies for cutting where they should be thinking of us shareholders first, but it’s not as black and white as that.

There are three reasons why firms are cutting dividends first and asking questions later.

Reason #1. Companies have never been through a single quarter GDP decline as horrible as this. Current estimates for Q2-2020 show that the median company expects GDP to decline about 30%.

This exceeds the worst quarter during the last recession by 4x!

Reason #2. Uncertainty of the recovery speed.

We know the playbook for a normal recession. Cost cuts and layoffs take hold. Bankruptcies spread far and wide, and then as always, human nature goes too far and cuts go too deep.

That sets up the recovery as demand comes right back.

This, of course, is not a garden variety recession but one driven by mandated government actions and a virus.

There’s no shortage of opinions about how we recover from this economically. However it happens, we can bet that companies will play it extra safe until things start trending up consistently.

Reason #3. The firehose of government intervention and stimulus is putting a ton of pressure on companies.

This has worked mainly to stop buybacks and dividend raises, but it likely played a role in some decisions to cut the dividends as well.

After all, it’s hard to ask for help if you are paying your shareholders their normal paycheck.

The Income Investors Ideas

Currently, I’ve published 56 income ideas – 42 of them are publicly-traded.

Of those 42, 13 have cut their dividend as a result of the pandemic.

That’s 31%.

Janus Henderson estimates that more than a quarter of the 1,200 companies screened in its Global Dividend Index have cut or deferred at least one dividend payment this year.

So, we’re on pace with that estimate.

But here’s the interesting part.

Dividend yields are still shockingly high!

Our average dividend yield today portfolio-wide is 18.1%.

The annual income we currently generate is over $30,000 a year on a total investment of just over $300,000.

And that’s AFTER the 13 cuts.

There’s an old saying – “the safest dividend is the one that’s just been cut,” so we’ll see if that holds up in these unprecedented times.

What Have We Learned?

Things that hurt, instruct.

Dividend cuts are painful, no doubt, but we can also take this as a teachable moment to set our expectations for dividends going forward.

If there’s one lesson that the pandemic threw out in spades, it was the need for diversification.

Anyone going “all-in” on one sector for yield likely got destroyed.

Pipeline MLPs and agency mortgage REITs had their models stressed to the maximum.

Because, hey, why not pile on and start a global oil price war in the middle of a pandemic? Looking at you, Saudi Arabia and Russia.

I teach and follow an 80/15/5 portfolio diversification strategy of income, value, and growth investments.

And recommend diversification within each of those buckets so while our MLP’s and mortgage REITs had dividend cuts, a few of our holdings in other sectors actually increased dividends.

That offsets some of the pain.

Will Dividends Come Back?

For that, we can go back to the futures.

Options and futures have a unique pricing mechanism that incorporates dividends likely to be received.

While options and futures themselves don’t receive or pay any dividends, they have to incorporate that amount in their calculations.

And those futures are suggesting that dividend cuts are peaking and dividend payments are likely to start increasing.

“Dividend futures have already bottomed and rebounded sharply, which is in sharp contrast to the (the next 12 months) EPS forecasts,” according to Morgan Stanley equity strategists Michael Wilson and Adam Virgadamo.

“Companies will always do their best to protect dividend payments and there is substantial empirical data on the strong signaling effects of dividends for stock prices,” they added.

They also point out that the futures market recently priced in a 15% decrease in S&P 500 dividends paid out this year compared to 2019 levels.

And they don’t see that as a bearish signal.

“If investors believe dividends will only fall 15% in such a terrible economic year, it should make them feel better about this stream of dividends in the future,” they concluded.

What’s more, they maintain that a 15% decline in S&P 500 dividend payments this year is too pessimistic: “We suspect many management teams will be reluctant to cut dividends.

So, if 32.5% of the companies have cut their dividend, but we’re only experiencing a 15% decline in actual dividend payments, then I personally call that a win considering we’re in the midst of the biggest economic disaster of my lifetime.

The dividend cuts have certainly bummed us income investors out but taught us something.

We have lost some dividend income, but let’s not throw the baby out with the bathwater as my Gramma used to say.

Going forward, the number of dividend cuts are set to decline, and it’s likely that dividend stocks start giving us raises again.

Be diligent, patient, and look for opportunities to pick up great companies at a discount.