What investors can learn from dividend cuts

Each results season, in the slow-plodding park run that is the London Stock Exchange, several stocks will fall off the pace and axe their dividend. So far in 2024, we’ve seen PZ Cussons (PZC), Close Brothers (CBG), Travis Perkins (TPK), St James’s Place (STJ), Vodafone (VOD) and Diversified Energy (DEC) hit the wall, and either reduce or abandon their cash distributions to shareholders.

That’s just in the FTSE 350, and excludes mining giants such as Glencore (GLEN), Anglo American (AAL) and Fresnillo (FRES), which have all responded to lacklustre commodity prices or operational issues by leaning on the flexibility in their payout policies.

Some corporates, yet to forget the wounds of recent cyclical downturns, have adjusted shareholder largesse to anticipate off years, or adapt to fast-changing capital priorities.

Glencore, for example, last month put up a reasonable defence of its decision to lower its final cash payout from 40¢ to 13¢ (31p to 10p) a share. Having inked a deal to buy Teck Resources’ (CA:TECK.B) coking coal operations for $6.9bn in cash in November, it was keen not to let net debt stray above a new self-imposed cap of $5bn. With tight reins on balance sheets now deemed essential to the resource sector’s investment case, short-term prudence on the cash front seems logical (as well as a convenient cover for 2023’s 61 per cent drop in adjusted operating profit).

But broadly speaking, dividends aren’t meant to be cut.

You needn’t take my word for it. According to the esteemed PowerPoint specialists at McKinsey & Co, there’s almost never a truly good reason for trimming a cash distribution. In an analysis of the US stock market from 1995 to 2021, McKinsey found that in a typical year, less than 2 per cent of non-variable dividend payers made a significant cut (defined as cutting the payout by at least a tenth). Of the 29 per cent of stocks that cut dividends at some point during the 26-year period, most did so during the 2008-09 financial crisis, or the 2020-21 pandemic.

“Virtually no large, stable company made a significant dividend cut out of choice rather than need,” McKinsey’s analysis concludes. The consultants’ prescription, therefore: chief financial officers (CFOs) should be alert to the risk that a dividend cut may foster the perception of “weaker earnings and lower cash flows ahead” and “investor blowback” – even when there is a compelling case to deploy capital elsewhere. Which, as the report suggests, is how CFOs already say they think about these things. Groundbreaking stuff.

Cash scarcity

One investing concept that I keep coming back to is scarcity. And dividend cuts, above all else, are about the scarcity of cash.

Executives might spin a cut as striking a better balance in the cash flow statement, as Vodafone finally did last week with its “rebased” (ie, halved) dividend and ambition to sporadically increase buybacks once its various asset disposals are completed. But given the choice, investors should always prefer to see a better balance being struck long before scarcity forces the need for such stark shifts in capital allocation.

Of course, for a certain school of finance, dividends are a meaningless game of pass-the-parcel. If you believe, as Franco Modigliani and Merton Miller argued, that cash distributions to shareholders are an irrelevance in the game of value creation, then cuts shouldn’t concern you.

On the other hand, if you own shares for income, then a company’s decision to cut its dividend is anything but an irrelevance.

Sometimes, it can strike as a wounding byproduct of a sudden change in fortunes (or mismanagement). Had it not junked its dividend amid a painful deterioration in the claims environment at the start of 2023, shares in Direct Line (DLG) might not have remained at the level that drew the recent low-ball bid from multi-line insurer Ageas (BE:AGS). Four months later after Direct Line’s shock trading update, on the other side of the Atlantic, shares in Paramount Global (US:PARA) collapsed after the media giant cut its dividend for the first time since 2009. Paramount shareholder Warren Buffett, who later reduced his stake, remarked at the time that it “is never good when a company cuts its dividend dramatically”.

Indeed, ordinarily, the idea that cuts are ‘sudden’ is probably a mis-characterisation. If companies rarely if ever cut their dividend from a position of strength, then it should be (and often is) apparent to investors that there are issues well ahead of time. Although its cash-preserving dividend cut came as a shock to faithful investors last month, the bad news coming out of wealth manager St James's Place (SJP) had turned into a steady drum beat since it first copped to the need for product reform last summer.

In other words, the loss of a dividend – whether abrupt, half-expected or long-delayed – tends to accompany bigger concerns.

Or maybe not. Last week, the housebuilder Vistry (VTY) again threw sand in the face of these considerations by confirming it had pulled its final dividend in favour of share buybacks. Repurchases are now “ordinary distributions”, with any surplus capital in the coming three years earmarked for “a special dividend”. Cue a 10 per cent one-day rally in the share price. A month earlier, Meta (US:META) shareholders reacted to a strong quarterly report and inaugural dividend by pushing up the Facebook-owner’s stock. Is there a unifying law beneath this inconsistency? Perhaps it's that the firmness or novelty of a capital allocation decision is cause for celebration. Go figure.

Buy on the cut?

All of which serves as either digression or roundabout context to a market theory that has gnawed away at me since I first saw it in 2018. In an article titled ‘Why companies that cut their dividend can be attractive income investments’, Schroders provided what seemed like compelling evidence that as well as being a symptom of corporate distress, dividend cuts might be a real signal that the bottom has been reached, and a market rebound is about to start.  

According to Schroders, in the decade to March 2016 the average UK-listed cutter saw its shares fall considerably, both in absolute and relative terms, in the year before cutting. But once the cut was made, the same shares would on average rise just over 7 per cent in absolute terms, just under 7 per cent relative to the market, and about 5 per cent versus their sector. After a year, cutters’ relative outperformance of the market and their sector jumped to around 14 and 6 per cent, respectively. After 24 months, the outperformance on both measures exceeded 20 per cent.

The report offered a few explanations for the apparent trend. First, that the dumb short-term money (or the needy income investor) is often liable to sell out once the high-yield rug has been pulled, and that this might magnify the market capitulation. Second, that freed-up cash “puts the business on a more sustainable footing”. An accompanying quote from Schroders value fund manager Simon Adler – “far better [a company] take that approach than overstretch its balance sheet to pay a dividend it cannot afford” – is more benign than McKinsey prepped us for, and points to the class of serious active manager that uses cuts as a contrarian signal.

Shortly after the period covered by the study, this dynamic played out very neatly within the mining sector. Cuts at Rio Tinto (RIO), BHP (BHP), Anglo and Glencore in early 2016, as part of efforts to hack away at leverage and respond to punishingly low product prices, sounded the bugle on a rally that would lead to the stocks’ sharp upward re-rating over the next two years. The lowering (or abandonment) of dividends would help create plenty more shareholder value.

This week, I asked Schroders for the data behind the report, and whether the asset manager had continued to track (or sought to exploit) the pro-cutter theory. There was nothing doing, and unfortunately, I’ve had little joy in replicating their findings for the post-pandemic market.

I did try. However, because companies’ distributions are determined by their own definition and whims, it isn't always easy to delineate the shape, purpose or presence of cuts. Attempts to neatly screen all the stocks that have cut their dividends in recent years have therefore stumbled.

Fortunately, the good people at www.dividenddata.co.uk have since the start of the pandemic logged a well-maintained list of UK cutters. In grouping and analysing this data, I’ve ignored cuts from 2020, after concluding that the singular nature of the Covid-19 crisis, as well as the range of reasons for lower cash payouts – from necessity, overcautiousness and even regulatory diktat – would prove too noisy to draw any firm conclusions.

What is clear, however, is that cuts are routinely preceded by share price declines, especially over 12 months. Second, share prices tend to do better in both absolute and relative terms following a full dividend cut, cancellation or suspension – at least compared with partial cuts.

Third, the only group that came close to mirroring Schroders’ 2018 findings were full dividend-cutting stocks outside the trust, fund or resources sectors.

Given this group is a sample size of 37, I hesitate to read too much into the detail. On balance, I can find little evidence that UK dividend cuts since 2021 have been a rich source of trading ideas. The notion that they should serve as a reliable contrarian buy signal, while deeply appealing to the event-based investor, is probably a bit of a chimera. Which makes sense: given dividends are a kind of surplus, they are rarely if ever the biggest obstacle to a surer footing.