As dividend income investors we ultimately choose our investment thesis primarily based on the state of the dividend payments that a particular company distributes. We check for sufficient current yield, dividend growth, sustainability and history of dividend distributions before we make an actual investment. Once we finally do pull the trigger and initiate a dividend stock purchase, we begin thinking about our projected income stream the new dividend stock will provide in the current and coming years. After all, our primary reason for investing in dividend stocks is to create an ever increasing income stream to supplement or fully fund our retirement years, whether it occurs at age 40, 50 or 60, the goal remains the same.

But what happens when a dividend stock you purchase cuts its dividend? Do you sell after a dividend cut? I know many dividend bloggers outline their criteria for investing in dividend stocks, among them an automatic ‘sell’ of any stock that has cut its dividend. But is this always the most prudent thing to do? I have always held the belief that any stock needs to be analyzed in a multifaceted manner. Just as I have typically written in many posts that a low PE alone does not a good investment decision make, neither does simply looking at a dividend cut as a simple black and white decision to sell a particular stock.

Companies often do not cut dividends out of the blue. Rather, several months of foreshadowing typically occurs before the dreaded cut. As investors for the long term we often tend to hold onto potential losers for fear of losing out on future dividend income. But, when it comes to dividend cuts one must ask several questions before actually unloading the stock.

First, one must ask if the reason for the dividend cut is a result of a systemic financial crisis such as experienced in 2008 and 2009. Many great companies were forced to temporarily cut or eliminate dividend payments simply because of unprecedented market conditions. But, as market conditions slowly improved and a general up tick in the domestic and global economy gained momentum dividends were reinstated and stock prices appreciated. Selling quality stocks that have slashed dividends simply because of rough economic times would equate to bad market timing as you would have sold at market lows.

Second, one must examine if there is a fundamental shift in the industry where a particular company has cut its dividend. You must always ask yourself the question of whether the company/industry is broken or is the stock broken. Of course, in the case of the former, a stock sale may be warranted as industry and company metrics may be fundamentally broken when there is an overall decline in the sector. Think of Kodak and the demise of film cameras. That industry as a whole was broken and not just the stock of Kodak. However, in the latter case, you might just have a broken stock in which case a buying opportunity may be presenting itself as industry and company fundamentals remain sound but only stock performance is broken. Think of McDonald’s Corp. MCD about ten years ago when the quick serve restaurants were still experiencing tremendous growth but the stock of MCD was broken and trading in the low teens. Though it wasn’t a dividend cutter, in 2004 you would have had an excellent buying opportunity in a great industry with a broken stock.

Third, one must consider the prospects of jettisoning historically high quality dividend paying companies simply because of a dividend cut and incur additional trading fees. An indirect benefit of dividend investing is that you inherently trade less frequently and thus save on commission costs. Studies have shown that trading in and out of stocks too frequently incurs the added expense of trading fees and often does not perform any better than buying and holding for the long run (even after a dividend cut). The very nature of investing in high quality dividend payers, by default, means you have an investment that is solid, reliable and predictable so why would you ever want to sell a position that possesses these qualities? Often companies that possess these high quality metrics reinstate their dividends and return to a policy of dividend raises coupled with capital appreciation.

Real World Example

Some examples from my real world portfolio that have experienced dividend cuts include investments in General Electric Company GE , Wells Fargo & Company WFC and Ingersoll-Rand Plc IR. In each case dividend cuts were drastic and was expected during the financial meltdown in late 2008 and 2009. I knew that the financial sector was in shambles and could tell that GE, especially back then, was very reliant on its financial division for its revenue and profits and was deeply impacted by mortgage losses like any other “standard” bank such as WFC. Though a solid dividend payer with a very friendly dividend policy I could see the writing on the wall with my WFC investment as well. In a similar fashion, though not a bank, I could see my investment in IR was also in danger of a drastic dividend cut as many industrial companies experienced tremendous slowdowns in new orders and overall revenue.

What did I do? I simply stuck to my dividend investing criteria and simply kept investing in each of the three companies despite a huge loss in stock value and dividend income. To me the notion of selling companies that I felt very strongly about and did not see an inherent weakness in their overall business operations or industry they were in seemed foolish. During those dark hours I could see the light at the end of the tunnel and that there would be a world with a GE, WFC and IR five, ten and even twenty years down the line. These were simply broken stocks and not broken industries. After all, the world is still very reliant on GE products, financial instruments from WFC and industrial goods via IR. In fact, each of the three companies have been raising their dividends, once again, for the past several years and IR even completed a spin off of its security business as Allegion plc Ordinary Shares ALLE which also pays a dividend. You can be certain, had I sold each of the three stocks, simply because of a dividend cut, I would have certainly missed out on some great capital appreciation and rising dividends. In fact, my GE holding is up about 20%, my WFC holding is up almost 60%, my IR holding is up over 120% and my spin off of ALLE, which did not cost me one dollar, is up over 155%.

The moral of the story is that dividend income investors should not simply equate a dividend cut with a stock sale. Dividend cuts alone do not necessarily show that a business is likely in trouble. You must examine all the reasons for the dividend cut and see if there is something fundamentally wrong with the company and/or sector it is in, or is the cut simply a temporary solution to a money crunch that a company is experiencing while the overall industry it operates in remains sound. Blindly selling stocks because of a dividend cut may not be the best solution for an overall dividend income portfolio.

Are dividend cuts an automatic ‘sell’ for your portfolio holdings? Please let me know below.

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