Every investor loves dividends, as this represents a direct cash inflow into an investor’s pocket.
Inevitably though, there will be times when investors experience a cut in the dividends. This may be due to various reasons which I will be discussing below, but the initial and expected reaction would always be one of disappointment. Investors should remember that a reduction in dividends is a fairly common occurrence and should not be taken as a sign that things are necessarily wrong.
Deterioration In Business Prospects
The most scary situation for an investor is when a company slashes its dividend due to a deterioration in business prospects. This may be due to stronger competition, higher expenses which impact profits, a decline in cash flow due to lower business volumes, or customers being unable to pay up due to challenging business conditions, just to name a few possible reasons.
Investors should scrutinise the financial statements and also read the Management Discussion and Analysis (“MD&A”) section to find out if the decline is likely to be persistent and permanent. If so, investors would have genuine cause for concern as this implies dividends may never be restored back to their original levels.
Low Of The Business Cycle
Another reason for the cut in dividends could be because the business is experiencing the low point of the business cycle. Economies are prone to regular business cycles, and recessions and booms are part of a normal cycle. Businesses are exposed to such cycles and demand for their products and services will also ebb and flow.
A company may experience lower business volumes due to recessionary conditions, which leads to a cut in dividends in line with lower profits. When the economy recovers, such businesses will recover alongside the economy and report higher profits and dividends.
Investors should take the opportunity to load up on such companies as the low of the cycle represents a good entry point, and subsequent increases in dividends will also greatly improve their dividend yield.
Cash Conservation For M&A
A third reason for reducing dividends is because a company may be gearing up for mergers and acquisitions (“M&A”). Conserving cash for such M&A may be a good or bad thing depending on what’s being acquired – investors have to assess this on its own merits.
However, if the M&A goes well, earnings will compound at a faster rate which will be reflected in growth in the share price. This will compensate the investor for the lower dividends he is receiving and I feel is a perfectly acceptable situation.
The Foolish Bottom Line
As can be seen from the examples above, a reduction in dividends is not always a bad thing. Investors should look closely at each situation to determine if the reasons for the cut are justified, and whether the cut is likely to be permanent or is just temporary. Sometimes a sharp reduction in dividends may even signal a good opportunity to buy more shares.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.