It goes without saying that dividend yield is an important consideration for income-hungry investors but so too is dividend growth. After all, a dividend payment that does not grow over time and therefore cannot keep up with inflation – or preferably outpace it on a consistent basis – will soon enough be of limited value to anyone.
This process is helped along by a number of factors, the first of which is that a cut allows a rebasing of a business’s dividends, thus permitting the company greater financial flexibility to tackle the issues that have caused it problems.
The hard choices made at this point enable the company to get back on a solid footing again, at which point they are quickly revealed to have dividends that are unsustainably low rather than unsustainably high. Rebasing dividends to a more ‘normal’ level means that, once a business has passed through its troubled period, its future pay-outs have greater potential for growth, even if profits take a prolonged period to return to their ‘pre-trouble’ levels.
A second consideration is that markets tend to take dividend cuts very badly and so any offending company’s share price will likely drop a long way. The combination of a depressed share price and an unsustainably low dividend is a powerful one – as can be seen from the following chart, which shows ‘cutters’ enjoying stronger dividend growth than the rest of the market over the next five years.
Source: Societe General, September 2014
Nor do we have to hunt around the lower reaches of the market for examples to prove our point. As you can see from this next chart, the low market expectations that follow dividend cuts would have allowed you to buy into some of the biggest companies in the UK at depressed prices and benefit from some very attractive growth indeed – both in terms of income and capital returns.
Source: Schroders, DataStream. Bloomberg. Data from 1 January 2006 to 31 December 2013
Thus, for example, after packaging giant DS Smith halved its pay-out in 2009, it went on to grow its dividend by at least 15% in each of the next five years – and 230% in all – while its share price rose 952% over the period.
One final important point to bear in mind here is buying companies that cut is not simply sacrificing upfront dividend yield for future growth – frequently you can obtain both. In the first chart above, the data shows the dividend yield on the companies that cut is not dramatically different from the dividend yield of the non-cutters. But how can this be?
The answer lies in the market’s reaction to the announcement of a dividend reduction. Lets say a company is perceived to have problems and investors believe a dividend cut is a high likelihood, then typically the shares will fall and therefore the headline dividend yield rises to, say, 8%. This means, even if the company does cut by, say, 50%, the cut would see the yield down to a still very acceptable 4%. At which level you have both an attractive yield and the potential for strong future dividend growth.
Do not therefore think of dividend cuts as merely reflective of past mistakes – they can also highlight a significant opportunity.