Should You Buy A Company After A Dividend Cut?

First published at ValueWalk.com

Should you buy a company after it has cut its dividend? That’s the question Morgan Stanley’s analysts have tried to answer in a European Equity Strategy research note sent to clients today and a reviewed by ValueWalk.

Morgan’s research has been prompted by renewed investor interest in dividend cuts. Against a depressed earnings base, the market’s dividend payout level looks high in a historical context and the median stock’s payout ratio is close to a 20-year high. On a pan-European level, the payout ratio has exceeded 2009 levels. It’s also important to note that this is not an anomaly that is limited to a few key sectors, the percentage of stocks with a payout ratio in excess of 60% of earnings per share has reached the highest level in 20 years.

As European investors have seen over the past few months, even those companies that were considered dividend aristocrats aren’t in any way immune from payout cuts with companies like Rolls-Royce, BHP, EDF, RWE and Repsol all cutting their dividends during the past six months.

An updated study 

This isn’t the first time Morgan’s investigated this question. Back in 2008, the bank conducted a similar research exercise and found that dividend cuts can indicate powerful inflection points in share prices. At the time, the research showed that investors could do well by buying stocks on dividend reductions, particularly those that are stressed.

In the 2008 version, Morgan’s research showed that UK companies that cut their dividend tended to outperform thereafter, especially if the shares had previously been poor performers, the payout cut was large or the starting yield was high.

In this updated version, Morgan examines 372 instances of dividend cuts in Europe over the last ten years. The stocks are based on the current constituents of MSCI Europe IMI, with a current market cap bigger than $2 billion. To qualify as a dividend cut, the company’s dividend payout has to be reduced by 5% or more.

Should you buy a company after a dividend cut?

The results of this study are rather interesting.

It appears that dividend cuts are indeed, often inflection points for stock performance. Morgan’s research on the 372 instances of dividend cuts in Europe over the last ten years shows that the median stock underperforms the market by 19% in the preceding 12 months but then outperforms by 11% in the subsequent 12 months, and by 19% by the end of year two. The probability of a stock beating the market in the following 12 months after a dividend cut is 65%, and 66% of the subsequent 24 months.

The research also showed that the strongest outperformance comes from stocks where the dividend yield ahead of the cut was 12% or higher with a hit ratio of 83% in the subsequent 12 months and 88% in the following 24 months. The weakest performance came from stocks trading on a dividend yield of 4% to 6% ahead of the announced cut.

Stocks that underperformed the market ahead of the dividend cut announcement tended to outperform the most after a cut. Among the stocks that underperformed more than 60% prior to the cut, 74% outperformed on a 12m basis and 86% outperformed on a 24m basis. The weakest subsequent performance came from the group that underperformed less than 20%, with a hit ratio of 61%, even on a two-year basis.

And lastly, the size of the dividend cut has an effect on performance after the event. In the 372 cases studied by Morgan’s analysts, the average dividend cut is more than 80%. Stocks that cut their payouts by more than 60% outperformed the most post the cut. The weakest performing group is the one that cut the dividend by 20% to 40% – even on a 2-year view, only 56% of such companies outperformed the market.

Dividend Cut – The bottom line 

All in all, this analysis from Morgan presents a pretty compelling argument: investors should buy stocks on dividend cuts, particularly those that have underperformed significantly ahead of the announced dividend cut, that previously had a very high yield, and those that cut their dividend by 60% or more.

This analysis is aimed at European investors and Morgan also provide some investment ideas in the form of stocks that cut their dividends in the last year and are ‘stressed’.

The High Dividend Yield Advantage

The evidence seems to suggest that by buying the highest yielding stocks you’re chances of outperforming the wider market are significantly improved. However, the evidence suggests that it’s not dividend yield, but dividend cover that is the key factor investors need to look out for when hunting for the best long-term dividend plays.

In an equity research paper entitled High Yield, Low Payout, Credit Suisse Group AG (ADR) (NYSE:CS) analysts Pankaj N. Patel, Souheang Yao and Heath Barefoot found that highest yield stocks were not the overall leaders in terms of return. The analysts ran a simulation of a dividend strategy from January 1980 to June 2006 using a universe of stocks within the S&P 500 and created equal-weighted declie baskets based on dividend yields.

Over 26-year period studied; they found a direct correlation between low payout ratios and higher returns within the higher dividend yield universe. To take a deeper look at this trend they created three dividend yield baskets ranked by yield; i.e., high yield, low yield, and no yield. Then, within each of these baskets they categorized stocks based on payout ratio; i.e., high, medium and low. Equal-weighted portfolios of these baskets were created based on dividend yields and payout ratios as of each quarter-end for the period January 1990 to June 2006. The high yield, low payout portfolio bucket generated an annualized return for the period of 19.2% versus 11.2% for the S&P 500. On the other hand, the high dividend yield, high payout ratio bucket produced an annualized return of only 11.0%, underperforming the S&P 500.