Honestly, even one would have been big news.
But just a couple of weeks ago, in a single day, two U.S.-listed high-yielding companies moved to either significantly reduce or eliminate their dividends.
Both are from industries income investors traditionally flock to, and both stocks dropped sharply on the news.
On August 3, large-cap Israel-based Teva Pharmaceuticals (NYSE: TEVA ) announced a 75% cut to its dividend payment. Afterward, the stock lost 44% of its market value in just five days. There is no doubt in my mind that the dividend cut was a major culprit.
Then there's the much smaller rural telecom company Windstream Holdings (NYSE: WIN ). This former high-yield darling is high-yield no more. Indeed, this company does not even qualify for a "yield" tag now. On August 3, Windstream announced that it would be eliminating its dividend. Naturally, the shares plunged. As I write this, WIN is down more than 75% year-over-year, with 45% of its fall coming in the five days since the announcement.
The Biggest Danger Faced By Income Investors
Often, big changes -- such as eliminating a dividend -- are preceded by certain signs that the company is considering or is likely to take that route.
This is why a year ago, in the August issue of my premium newsletter, The Daily Paycheck , I decided that I wasn't quite comfortable with the deteriorating financials and other signs of slower business for small-cap Orchids Paper Products (NYSE: TIS ) . I quickly removed the stock from my portfolio and advised my readers to do the same. And boy am I glad I did.
About nine months later, Orchids Paper announced that it would be suspending its dividend to preserve capital. The stock, as you can see from the chart above, is down 64% from a year ago.
Of course, the company's finances could have recovered. But this was one of those archetypical "better safe than sorry" cases where the likelihood of the company's cutting or, worse, suspending its dividend seemed higher than the possibility that its business would be strong enough for it to continue paying its dividend in full.
These examples illustrate one of the biggest dangers affecting equity income investors. Cutting a dividend is usually a measure of last resort: When a company can no longer fulfill its dividend obligations, this also signals to the market that its business is facing a worst-case scenario. If the dividend cut is unanticipated by the market, the effect can be devastating.
In most cases, dividend reduction results not only in a lost income stream but also in the price decline of the underlying stock. Sometimes, the markets see the upcoming dividend reduction and preemptively devalue the stock. Even in these cases, dividend cuts and share-price drops most often go hand in hand.
Predicting A Dividend Reduction
The first line of defense any equity investor can build is to make reasonably certain that the companies he or she owns are not likely to cut their payouts. Doing that protects both the value of the portfolio and its income stream.
Of course, it isn't always obvious. In some cases, there are many more "tells" that a cut might be coming. Here's a quick -- and by no means all-encompassing -- rundown of some of the things Teva and Windstream had in common.
1. Increasing debt load: Both companies had significantly increased long-term debt on their balance sheets from FY 2015 to FY 2016.
2. Slowing or declining profits: Both companies also shared this tell. Teva's profit has been slowly deteriorating, while WIN hasn't been profitable since FY 2014.
3. Declining cash balance and declining free cash flow: Both companies exhibited both of these signs (albeit to a different extent).
4. Deteriorating business: This was the case for both Teva and Windstream as well. This tell is much less quantifiable, but you can often roughly assess a company's business conditions by comparing its fundamentals to its peers. One such fundamental is its dividend yield. If it's abnormally high compared to the industry average, or if the company's industry peers have been reducing their dividends, then you do have to dig deeper.
With this in mind, I went through my Daily Paycheck portfolios and reviewed the equity positions for even the slightest hint of a possible dividend cut. I suggest you do the same for your portfolio.
Remember the best part of such a deep dive is that, even if you are wrong and the companies you've chosen to cull from your portfolio continue to pay, you will have likely weeded out the weakest links -- companies with the worst financials and the riskiest business situations. That will free up capital for you to pursue better opportunities in stronger dividend-paying stocks in the process.
It's always good to check and recheck your portfolio for the signs mentioned above -- but it's especially good now, with the market volatility rising and stocks still trading near all-time highs.
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