How to Avoid Dividend Cuts

Dividend cuts can be a significant blow to investors, as they not only reduce the income received from a stock, but also often signal financial difficulties for the company. However, there are steps that investors can take to avoid or mitigate the impact of dividend cuts. 

In this article, I will explore strategies for identifying companies at risk of cutting dividends and ways to diversify a portfolio to reduce the overall risk. Whether you're a seasoned investor or just starting to build your portfolio, this information can help you protect your investments and potentially even increase your returns.

What are Dividend Cuts & Why They are Important to Investors

A dividend cut means that a company on a stock market will reduce their dividend payouts, or sometimes completely stop paying dividends. One example I can give from my own experience is with General Electrics, who slashed their dividend payouts by half in 2017. In that case - and this is the case for most dividend cuts - the company simply didn't have enough cashflow anymore to cover the dividend distributions, and did the cut to avoid having to get too much money out of their accounts to pay the dividends. 

In terms of impact on a investment portfolio, it's pretty nasty. First thing is that of course you will loose some yield on your portfolio if you are tracking the overall dividend yield of your whole portfolio, which can have a pretty big impact if the company had a large position in your portfolio.

Second thing is that in general companies that cut their dividends will also immediately loose a lot of value, because it is a really negative signal to investors as it indicates problems with the financial health of the company.

With that in mind, let's now see two ways to reduce the impact of potential dividend cuts in your portfolio: first by avoiding them in the first place, and then by reducing their impact on your overall portfolio.

Avoiding Dividend Cuts by Carefully Analysing Stocks

The first thing you can do is to avoid having dividend cuts completely in the first place. I do this on my own portfolio by doing two things: carefully analysing dividend stocks I consider for my portfolio before buying them, and also closely monitoring my portfolio over time.

The first thing you need to check is an indicator called the payout ratio. It is basically the amount of dividends distributed to investors of the company, divided by their current profits. If this ratio is over 100%, it means the company currently has to take money out of their own pockets to pay their dividends, as they don't make enough profits to cover it. This is a bad sign - and can definitely indicate a dividend cut in the future.

You should also look at the growth of dividends over time. Usually, companies that are good dividend payers have a tendency to raise dividends over time and in a really linear fashion, so if you see that a company that was growing their dividends slowly start to slow down this growth over time, it might also indicates that they are having problems paying their dividends.

Then, you can also have a look at other financial health indicators that you will find in the company financial statements, that are usually released quarterly. But checking those two indicators I mentioned usually does the trick.

For example in the case of General Electric that I mentioned earlier, the payout ratio was clearly too high for the company to sustain their dividends payouts, and I should have sold the stock before they actually announced the cut.

So my advice would be to just check those two indicators and either don't buy a stock or sell it in case it's already in your portfolio if one or both of them are telling you a dividend cut might be on the horizon.

Diversifying your Portfolio to Reduce the Impact of Dividend Cuts

Avoiding dividend cuts of course won't always be possible and even with a careful analysis and monitoring of your portfolio, it might still happen sometimes. 

What you can do however to reduce the impact of those cuts is to have a really diversified portfolio.

Let's say you invested in just 4-5 stocks, with the same amount invested in each of them. If one of those companies goes through a dividend cut, it will have a strong impact on your portfolio, with a reduced overall dividend payout on your portfolio and a potential loss of capital.

Now if you have 40 or 50 different stocks in your portfolio, the impact of one or even two having a dividend cut will be way smaller, and won't impact that much the overall performance of the portfolio.

Therefore I really recommend having a really well diversified portfolio to reduce the impact of a potential dividend cut on your portfolio.

Where to Go From There?

I hope this article gave you some idea on how to avoid dividend cuts and what you can do to reduce the impact of those dividend cuts on your portfolio.

If you want to learn more about how to invest in dividend growth investing and learn how to build a solid portfolio, I recommend you to check this free guide that I created

All the best with your investments!