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Portfolio Update

Cutting Both Ways: The Pluses and Minuses of a Dividend Cut

By Roger S. Conrad, on Mar. 31, 2015

A rising dividend drives price appreciation over time. Dividend cuts, on the other hand, send stock prices tumbling and shrink investors’ income streams—a painful double whammy.

And although the company ostensibly strengthens its balance sheet by retaining more of its cash flow, the higher cost of equity capital can linger for years.

For these reasons, companies go to great lengths to avoid reducing their dividends, in some cases exhausting reserves and credit lines in the hope that profits recover sooner rather than later.

Though painful and often regarded as a last resort, a dividend cut can make sense, especially when companies find themselves on the wrong side of the business cycle.

A dividend cut forces investors to evaluate whether they should wait for a turnaround or take their losses. The big question is whether the dividend cut marks the nadir of the company’s fortunes or the prelude to more downside—unfortunately, there’s usually no easy answer to this dilemma.

The regulated utilities I cover in Conrad’s Utility Investor have an impressive track record of coming back from disasters—including those of their own making. Even the half dozen that sought to mimic Enron’s business model in the 1990s have recovered and are in better shape than ever.

In prior decades, utilities have found their way back from billions of dollars in cost overruns on nuclear power plants and investments in busted savings and loan associations.

However, downtrends in cyclical industries can present more of a challenge. The law of inertia also applies to stocks: Equities in motion tend to stay in motion, especially on the downside.

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