Things are not always what they seem
Today I want to discuss every dividend investors’ worst nightmare: a dividend cut. In most cases, dividend cuts are catastrophic. When you think about it, a company would likely save its shareholders from the pain of seeing their income being slashed. When management comes to the point where it grabs back the money it was supposed to give you; this is because it has not other options left. A dividend cut is a confession of mismanagement. A confession the company failed their shareholders. But did you know that not all dividend cuts are obvious? Some are done in plain sight, some dividend cuts are done in disguise…
Dividend cuts are obvious
When management announces a reduction of their dividend, the news spread faster than a contest to win two tickets for the NFL Super Bowl. Media will use powerful words such as “axed”, “slashed” or even “killed” (this reminds me of my time in El Salvador and Honduras!?!). It is then quite easy for investors to know what is going on and take action. According to my investing rules, a dividend cut is a stock to sell…now.
Dividend cuts in disguise
While the financial press does an amazing job at reporting dividend decreases, it does an awful job at tracking down hundreds of companies fooling income seeking investors. Those companies cut their dividend in your face and nobody is saying anything. Even worse, most investors are happy about the situation! The problem is all in perceptions I guess. While everybody sees this:
I actually see this:
You got it right! While many income seeking investors are super happy to hold generous shares of Compass Diversified Holdings (CODI), they all forget that the 8%-9% the company is paying doesn’t move. This is definitely not a problem at first, but 10, 15, 20 years from now… things get ugly because my good friend “Mr. Inflation” invites himself to the party.
By keeping the same dividend for years, your payout is getting eaten alive by inflation. Each year, it’s like you would be suffering from a 2% dividend cut. You don’t see it, you don’t feel it, but 10 years from now, it’s going to hurt.
The “non-increase” is the first step to the dividend cut
As the inflation rate hasn’t been too bad over the past 10 years, most income seeking investors don’t really mind it. Many tell me, “Mike, I’m retired and I need this 8% income, I don’t care about inflation”. Okay. I get it. Imagine you have $1M invested at 8% and you only need $60k/year to live. This means inflation can eat up $20,000 before it affects your lifestyle. Make sense. Sort of.
The problem is that many companies that keep their dividend as is will eventually cut it. You know why? Because if management can’t increase its payout, it is most likely because the business isn’t doing that well. I tried to find companies where they were showing growing revenues and earnings but with no dividend increase over the past 5 years. They are pretty rare. In fact, most “non-increasing” dividend paying stock will eventually look like this:
As you see, with poor shareholders of New Senior Investment Group (SNR); they lost both their source of income (-43.5%) and their investment (-63.6%).
I’ve obviously cherry-picked my examples with CODI and SNR here. I always find it easier to show real-life example (a bit extreme) to show classic investing principles. In the end, when a company stops increasing its payout, you should start wondering why it happens. Not all companies will end up with the above-mentioned scenarios. But thinking no dividend raise for the past 4-5 years is a good sign would be the definition of “investing naiveté”.
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