The Clientele Effect – When Dividend Cuts are Attractive

By PAIP Canada staff

            The typical reaction to a dividend cut is a reduction in a company’s share price, and why wouldn’t it be? It seems rationale. If an investor is being paid a certain amount to hold a stock and that amount is reduced, why continue holding the stock? It’s similar to showing up to the office on a Thursday morning and being told that your salary has been cut from $120,000 per year to $85,000 per year. No one would simply accept it and continue doing their job.

            The Clientele Effect is a term used to identify the matching of investors and company shares. In many cases, retired investors seeking regular income will invest in mature companies that pay above average dividends. Similar to this are when younger investors (with a long-time frame) invest in growing companies that do not pay dividends. Instead, they want to be rewarded with a higher share price.

            Although dividend cuts are usually bad for existing shareholders, they can sometimes lead to buying opportunities for others. As an example, if a company cuts its dividend by 75% (from $1 per share to $0.25 per share), then the new dividend (and lower share price) may translate to an opportunity. If the previous share price was $10 and the dividend yield was 10%, then clearly far too much of the company’s cash flows were being spent on the dividend. Following the dividend cut, the new share price may drop to $8 for a new yield of 3.125% and provide upside potential.

            The reason for this is because the new (lower) dividend provides company management with room to manoeuvre, and eventually increase the dividend once again. With a new dividend of 3.125%, investors should assume that the company will have capital remaining after paying the dividend. Following a dividend cut, the payout ratio also declines, sometimes substantially.

            At the end of the fiscal year, good companies typically earn a profit, while bad companies sometimes earn a profit. For investors, there is one thing that cannot be altered: each company earns only so much in a given year. The money retained plus the money returned to shareholders (through dividends and share buybacks) will always equal 100%. As a result, investors should consider each investment for its total return instead of its dividend return only.

            Remember: investments are made based on future expectations, not on past results. There is no substitute for hard work.