Wednesday, February 27, 2013

Dividend Cuts: Throwing A Wrench In The Gears Of Retirement

Dividend growth is the heart and soul of my retirement strategy. With every dividend increase, my wealth grows like a compounding machine. As my dividend income grows, it wards off the effects of inflation and my money retains its buying power. A dividend cut can cause your compounding machine to go off the rails and set you back years of dividend growth. That’s why it’s crucial to invest wisely in companies that are unlikely to see a dividend decrease.


Dividend cuts allow a company breathing room when their finances aren’t keeping up. Companies lower the dividend so that the excess cash can be used to help the company recover and get back on track. Whenever a company declares a dividend cut, the share price usually drops significantly as investors lose confidence and look for more stable investment and I can’t say as I blame them. No company is immune to dividend cuts, but luckily there are some simple ways to help you avoid the companies on the chopping block.

Super High Yield

Too much of a good thing, especially when it comes to dividend yield, can be bad for you. I’m a little cautious of a dividend stock that has a yield over 6%. There are many factors as to why a yield might be higher then most, but normally it means the dividend could be too big to maintain.

As a stock price decreases, the yield increases which can be enticing to investors. The stock price could be low due to market turmoil, but there could also be a more ominous, underlying reason. Perhaps the company is involved in a huge scandal or simply the company has become obsolete, just like a certain phone book company we all know about.

Dividend Payout Ratio

Before investing in any dividend paying stock, one must always look at the dividend payout ratio. It’s the ratio between the amount of dividends paid per share compared to the earnings per share. When the earnings coming in are lower then the dividends that are paid out, then there’s definitely something wrong. The dividend will most likely be on the chopping block in order to balance the finances.

To find the dividend payout ratio, simply divided the yearly dividend by the latest earnings per share. The lower the percentage, the safer the dividend. I like dividend ratios to be around the 50% range. Anything higher then 80% leaves me with a bad feeling in my stomach.

Just Plain Wrong

Recently there was a company that cut its dividend by a whopping 32% from $1.24 to $0.84 a share. This dividend chopper is Just Energy and they sign up people for contracts with natural gas and electricity, which is red flag number one. The company is based on being a middleman for energy suppliers. Not a very solid business model for my liking.

I remember hearing other financial bloggers raving about Just energy a while ago so I looked into them to see what all the fuss was about. The first thing I looked at was the dividend history and that was red flag number two. The dividend history was very irregular which would really cause havoc to anyone relying on it as income in retirement.

The dividend yield was quite high at around 10% in 2010 and that was red flag number three. I’ve seen BMO with a yield of 10% after the markets crashed in ’08 and ’09, but BMO has been around longer then some provinces in Canada. Just Energy has been around since 1997 and I think I still have underwear from that year.

The dividend payout ratio for Just Energy is 98% which is waaay to high. Cutting the dividend was the right choice to help them recover financially. Since the announcement of the dividend cut on Feb 8 2013, the stock has dropped significantly and will probably do so for quite some time. Any company that cuts there dividend will see a huge loss in share price as investors flock to more reliable investments.

Play it Safe

There are no guarantees when it comes to investing in stock markets, but there are warning signs like the ones I mentioned above that are easy to see so that anyone can make smart investment decisions. Well established companies that have paid consistent dividends over the years are not immune to dividend cuts, but they do manage their business around paying investors and for that reason investors will stick with them over the years. I don’t invest in hyped up or popular tech/media companies that are the flavour of the week. I invest in boring companies like banks, utilities and consumer goods because they are established and have the history of solid growth. I may not get rich quick this way, but I will eventually and that’s just fine with me!

This article was written by The Loonie Bin. If you enjoyed this article, please consider subscribing to his feed.

2 comments:

  1. I would prefer a strategy with 2-3 percent dividend yield and 5 percent organic growth of the company. In total you should realize a 8-10 percent return.

    High yields are no solution if you have a small dividend income. Growth is the only trigger that makes you rich.

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  2. All the more reason to monitor your positions. Changes in the economy effect every company differently. There's almost always a warning sign before a cut is announced. Sometime's it's pretty clear and sometime's it's very murky, but if you're not 100% comfortable with owning that company, then cut ties before the cut.

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