It’s Halloween season, so I thought it would be appropriate to discuss one of the most feared events in the equity markets: dividend cuts.

For income oriented investors who rely on the passive income that their portfolio generates, there are few things worse than a slashed dividend (cue the Michael Myers theme song).

It’s important to understand that no dividend is inherently safe. The fact that dividends can be cut is why many individuals avoid stocks.

The following chart shows the enduring appeal of dividends:

However, despite the importance of dividends, investors shouldn’t necessarily freak out when a dividend gets cut.

In the last week or so we’ve seen several well known companies hack and slash their dividends. Anheuser-Busch Inbev (NYSE: BUD), the world’s largest brewer, recently posted an earnings report that included a 50% dividend cut. General Electric (NYSE: GE) made news last December when it cut its dividend by 50%, from $0.24/share to $0.12/share.

At the time, many analysts said that GE’s dividend cut wouldn’t be enough to solve the company’s balance sheet issues. This week, they were proven correct as new management cut the payment again, down to $0.01/share from $0.12/share.  And just yesterday, Owens & Minor (NYSE: OMI), a company with a long and illustrious dividend growth history, surprised investors with a whopping 71% dividend cut. 

Adding insult to injury, the shares prices of these companies plummeted on the dividend cut news. With BUD, there had been rumors of an upcoming dividend cut for weeks. However, when it was announced the stock fell double digits.

General Electric hit 52-week lows yesterday and Owens & Minor’s stock dropped 44%. Dividend cuts are never truly priced into the market, which is why they’re often associated with this negative price action.

While there is no sure-fire formula to follow when hoping to avoid dividend cuts, there are a handful of data points that generally point towards a dividend’s safety and health. 

Crucial Dividend Metrics

First and foremost, it’s important to check the quality of a company’s balance sheet. Irresponsible debt levels are often the enemy of dividend safety.

An easy way to track the health of a corporation’s balance sheet is to check the credit scores assigned to the company by the major credit agencies. If a management team can’t secure an investment grade credit rating, how can you expect them to provide a secure source of passive income?

Another quick and easy metric to check is the earnings per share (EPS) dividend payout ratio.  Acceptable payout ratios vary from industry to industry. Certain industries, like utilities, telecoms, and consumer staples that have reliable cash flows are given the benefit of the doubt by the market.

More cyclical industries like industrials, transports, and consumer discretionary names require a wider margin of safety. A general rule of thumb when looking at payout ratios is to target 80% or less for utilities, telecoms, and certain specialty industries like tobacco, and 50% or less for other dividend payers. 

If a company’s payout ratio is 50% or less, it can experience issues with earnings growth and still maintain, or even increase, its dividend. This responsible stewardship of shareholder returns is why there are companies with multi-decade long annual dividend increase streaks.

Dividend aristocrats experience hard times during recessions just like the rest of the market, but they’re still able to reward shareholders with rising income because of the high quality of their management teams.

With regard to EPS growth issues, it’s important to track sales growth. Income oriented investors want to see reliable EPS growth, but this isn’t possible over the long-term without similar sales growth.

Bottom line issues begin as the top-line erodes. Management can use efficiency measures, cost cutting, and financial engineering methods such as stock buybacks to bolster the bottom line in the short-term.

However, if there is not regular (or better yet, increasing) demand for products and services to drive sales, a dividend can’t be considered safe over the long-term. Consistent negative sales growth often represents industry disruption, which can be dangerous for an income oriented investor.

Due diligence should go deeper than credit scores, payout ratios, and EPS and revenue growth. But these metrics are good places to start. While the threats of dividend cuts can be scary, it’s important to remember that the U.S. equity market has produced unparalleled wealth creation for investors over the long haul.

Furthermore, dividend growth provides protection from inflation that bond yields do not. All investments come with risk, but you don’t have to be scared if you know what to look out for. 

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