A little over two years ago several dozen former Canadian income trusts converted to corporations. The move was long expected in response to new taxes first announced in October 2006. And the big surprise was the market’s primary reaction: bullish.

When it was first announced Canada’s prospective tax on trusts set off a wave of panic.

Prices dropped sharply to reflect dividend cuts far beyond the size of the tax.

By Jan. 1, 2011, when the Specified Investment Flow-Through (SIFT) tax went into effect, many trusts had either been swallowed up in mergers or vanished as businesses during the turmoil of 2008.

But it was clear for the remaining trusts that the post-tax world would be far more benign than initially thought.

The majority of former trusts that converted to corporations, as well the minority that remained SIFTs, have now absorbed the new taxes for two years.

Many, however, never cut dividends at all, while others reduced by much smaller amounts than anyone thought.

Trusts’ share prices began to recover in early 2009, along with the rest of the stock market.

But their rally accelerated when the first group began to convert to corporations with little or no impact on dividends.

And since the January 2011 conversion wave cutters and non-cutters alike have been off to the races.

Parkland Fuel Corp (TSX: PKI OTC: PKIUF) wound up cutting its dividend from a monthly rate of CAD0.105 per unit paid as a trust to CAD0.085 when it converted in January 2011. But the company, which announced its first post-conversion dividend increase last month, has returned more than 80 percent since then.

Parkland’s share price has had plenty of ups and down the past couple of years, and it did take a brief spill right around the time the dividend cut was announced. But selling on news of Parkland’s dividend cut would have been a critical mistake, just at it would have been for the vast majority of converting trusts that also reduced payouts.

Since the conversion wave 36 Canadian companies tracked in How They Rate have cut dividends. The table “After the Cut” has the details. The reasoning for these cutters was far different than the converters. Mainly, underlying businesses were weakening, and management could no longer afford to pay out at the current rate.

What hasn’t been different, however, has been the eventual market response to their moves. Almost all of them took an initial hit on the day of the announcement. The hit was more benign in cases when investors were expecting the blow and more severe when it was mostly unexpected. And the magnitude of selling was also affected by the market mood.

The vast majority of cutting companies, however, have moved to higher ground.

In fact the only companies that went further underwater were those whose continuing demise forced them to cut at least once more.

Before the Dawn

As the old saying goes, it’s always darkest before the dawn. And, being emotional creatures, we investors always imagine the worst when a favored company surprises us with a dividend cut.

In my case, when a recommendation or personal holding reduces its payout I feel like I’ve been had. And my first emotional reaction to get under control is to lash out by selling the offending stock.

For other investors the prevailing feeling might be despair, or more likely fear that this bad news is only the tip of the iceberg on the way to complete wipeout. And the immediate reaction is also to sell at whatever price is available.

Some dividend cutters certainly have gone lower the past couple years and going back further as well. Dividends to a large extent are how dividend-paying stocks are valued. A company with a reputation for dividend safety will have a much easier time raising equity capital–and growing without running up debt–than will a company considered risky.

That’s why no sane management willingly cuts its dividend, particularly in the current environment where fearful investors routinely punish offenders with crushing selling momentum.

Rather, such moves are always made when there’s duress at the underlying business.

The key to recovery is that the dividend cut and other measures taken concurrently stop the internal bleeding and buy management time to get the recovery in motion. Dividend cuts almost always hurt stock prices initially, making it less attractive for companies to mint new shares.

But they also accomplish two things that are potentially very favorable to business health.

First, a dividend cut saves internal cash, which is the cheapest capital available. If a company manages its cash right it can tailor a dividend cut to the penny to raise the capital it needs for other recovery measures.

These typically include paying down debt obligations and other liabilities. But the money can also be used for the business to expand or to remediate some sort of cash-draining problem, needed steps for the company’s ultimate recovery.

Dividend cuts can also be a big plus in company dealings with creditors. Credit raters generally look favorably on such measures to save cash. So do bank lenders, which are usually the chief creditors for small to intermediate-sized Canadian companies. A dividend cut made in consultation with lenders may free up lower-cost funding for companies, providing a major spur to recovery.

It’s the growth of the underlying business that will ultimately pull a company from rags to riches. And dividend cuts often provide the necessary spur to get things back on track.

At the same time investors are lamenting the demise of a long-held dividend-paying stock, the underlying company has sown the seeds of its ultimate recovery. And the prices hit in the post-cut gloom prove to be the lows, as improving businesses gradually work stocks back to higher ground.

Tip of the Iceberg

There are definitely times when a dividend cut really does augur a longer-term demise, and the stock winds up going a lot lower. The Canadian energy sector has been rife with these over the past several years.

The root of the problem is energy prices. The development of shale reserves has set off an unprecedented oil-and-gas boom in North America at the same time global demand is exploding.

China’s massive growth, Japan’s sudden aversion to nuclear power and scores of factors mean whatever is produced and not used here can be sold elsewhere, even if Europe remains a basket case for the foreseeable future.

As I explained in the February In Focus feature Canada’s Oil Discount: Opportunity and Risk, the challenge is finding energy midstream infrastructure to get the energy to market.

And until that’s resolved oil and gas is going to sell at far lower prices where it’s produced than where it’s consumed.

Large, deep-pocketed players can afford to absorb today’s lower prices in expectation of much higher profits to come.

Chinese, Korean, Malaysian and American energy giants have continued to make major investment in Canada to develop immense natural gas, light oil and oil sands projects in anticipation of vast improvements in marketing channels.

Unfortunately, smaller players have increasingly faced the choice of either allowing debt to ramp up to dangerous levels, abandoning development critical to sustainability and growth, or to cut dividends. And, not surprisingly, they’ve chosen option No. 3, taking the hit to share prices in hopes that energy prices would give some relief eventually.

In the case of new Aggressive Holding Enerplus Corp (TSX: ERF, NYSE: ERF), a single cut in June 2012 appears to have done the trick.

Like all former energy trusts, the company’s dividend has had its ups and downs over the years. But Enerplus as a business has been able to weather the ups and downs in its industry, growing output and consistently maintaining solid financial health. And, as I point out in this month’s Best Buys feature, fourth-quarter results demonstrate immense progress in every key area for this company.

That should enable it to avoid the fate of Perpetual Energy Inc (TSX: PMT, OTC: PMGYF).

Perpetual has had the misfortune of being a 90 percent to 100 percent natural gas producer throughout North American gas’ long descent from its late 2005 peak in the upper teens in the wake of hurricanes Katrina and Rita to the most recent bottom last year of less than CAD1 per million British thermal units in parts of Alberta.

Formerly known as Paramount Energy Trust, Perpetual has pulled the dividend-cut trigger many times. The last was Oct. 19, 2011, when it stopped paying dividends entirely. The stock is down roughly 50 percent from that point.

None of the small oil and gas producers in the table “After the Cut” have performed well since cutting dividends. The most recent sector cutter–Bonavista Energy Corp (TSX: BNP, OTC: BNPUF)–trimmed its payout by 41.7 percent in early January.

This move was widely anticipated and was reflected in the share price beforehand, demonstrated by the lack of investor reaction the day of the cut. But the stock has dropped another 9 percent since, adding to a 36 percent loss over the last 12 months.

AvenEx Energy Corp (TSX: AVF, OTC: AVNDF) is merging with two other small energy producers in a move that may save all three. But AvenEx stock is still down 44 percent since its last dividend cut in March 2012, as investors anticipate another cut at merger close.

And Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF) is off more than 44 percent since its September 2011 dividend cut of 28.6 percent, which was followed by another 40 percent cut roughly a year later.

A big problem for small oil and gas companies is that they lack the scale to weather weak prices caused by having their energy so far from market. And the more they cut dividends the less attractive is their stock to investors, and the more they have to rely on lenders, never a good strategy for long-term growth.

Those that survive today’s environment will likely see their share prices go a lot higher in coming years. But for many the best option may be selling themselves to the highest bidder in a low-valuation market, much as Advantage Oil & Gas Ltd (TSX: AAV, NYSE: AAV) appears to be doing by forming a special committee of its board of directors last month.

Small oil and gas producers’ current vulnerability is the main reason I advise avoiding most of them for at least the near term. The same holds true for small services companies, which provide rigs and other equipment needed for drilling.

Larger services companies can deal with big producers, whose plans remain on track despite pricing differentials.

Smaller players by their nature deal with smaller producers, which may have no choice but to cut back.

Thus far the only service provider to cut dividends is Poseidon Concepts Corp (TSX: PSN, OTC: POOSF), which based on incoming evidence looks more and more like a fraudulent organization.

Trading has been suspended in the stock as a special committee tries to get to bottom of what appears to be unreliable accounting.

There’s no shortage of shareholder suits being launched, though any meaningful restitution seems unlikely.

We did see fourth-quarter profit pressures, however, in several of the energy services companies tracked in How They Rate. Although valuations are already very low, based on anticipation of dividend cuts, this is an area to be careful of at least so long as differentials are hurting drilling activity.

Recovery Stories

The good news is outside the energy sector dividend cuts have generally marked the bottom for companies.

There have been exceptions, such as Yellow Media Ltd (TSX: Y, OTC: YLWDF) and Royal Host Inc (TSX: TWX: RYL, OTC: ROYHF), which started down and kept on going. But even Imvescor Restaurant Group Inc (TSX: IRG, OTC: IRGIF) shares are up since the company eliminated its dividend two years ago.

Perhaps the most interesting story is that of Canfor Pulp Products Inc (TSX: CFX, OTC: CFPUF). This low-cost processor of pulp products cut its dividend when it converted to a corporation in January 2011.

A year later, however, it began facing headwinds in pricing for its products as well as forestry inputs.

The result was a 37.5 percent dividend cut in February 2012, followed by a 12 percent cut in May, a 77.3 percent cut in July and, finally, the elimination of the payout in October.

In February 2013 the company restored a quarterly payout of CAD0.05 a share. That’s a level 87.5 percent below what it paid before the February 2012 cut.

But the stock is down just 12 percent from that level and is actually up 30 percent from the July 2012 cut.

Canfor’s business is very volatile. But we’ve seen much the same action from Westshore Terminals Investment Corp (TSX: WTE, OTC: WTSHF), which is up 30 percent since its December 2011 dividend cut.

That’s despite having suspended its payout in response to an accident that temporarily put a shipping berth out of commission.

The poster child of the past two years for post-dividend cut recovery is Superior Plus Corp (TSX: SPB, OTC: SUIIF). The company actually converted to a corporation without cutting its dividend, but by March 2011 several segments of its business were weakening.

Management cut first on March 10, 2011, by 25.9 percent and then again in November 2011 by another 50 percent. But the stock is up 18 percent-plus from the first cut and by more than 90 percent since the second.

The reason: Superior Plus has stabilized earnings at its various operations, from construction materials and chemicals to propane distribution. It also used the dividend cut savings to slash debt, and the market has noticed.

It may be a while before Superior actually raises its dividend again. But management has laid out guidance for 2013 that should give it plenty of latitude to keep executing on debt reduction goals, even as it improves profitability by boosting efficiency on the operating level.

This is the anatomy of a successful post-dividend cut recovery: Management saves enough cash to carry through a series of initiatives that stabilize the business and put it on track to resume growth, which in turn steadies earnings and provides a level of comfort for the reduced dividend, setting the stage for a share-price recovery.

Difference Makers

So what does make the difference between a dividend cutter that recovers and one that keeps going down into oblivion?

The answer is critical for five current Canadian Edge Portfolio picks that have cut dividends in the past 12 months: Atlantic Power Corp (TSX: ATP, NYSE: AT), Colabor Group Inc (TSX: GCL, OTC: COLFF), Enerplus Corp (TSX: ERF, NYSE: ERF), IBI Group Inc (TSX: IBG, OTC: IBIBF) and Just Energy Group Inc (TSX: JE, NYSE: JE).

All of these companies couched their moves as necessary to save cash to keep development plans on track. Management also laid out post-cut recovery strategies along with benchmarks for gauging their progress.

Given that their cuts occurred in the past month, it’s far too soon to get a read on how Atlantic and Just Energy are faring. I focus on Atlantic’s prospects in Dividend Watch List.

Just Energy’s only developments are a statement from management to analysts that it’s “confident” the new dividend is “sustainable” and announcement of a plan to buy back up to 7.4 percent of its shares as well as some convertible bonds over the next 12 months.

These are indeed favorable signs, as are recent analyst upgrades of the stock. But we’re not really going to know how post-cut plans are faring until mid-May, when operating and financial results are announced.

The same thing is true of IBI Group. The company’s work has won several awards recently, which should ultimately be good for its ability to win new contracts. And it too has received several analyst upgrades, leaving the count at three “buys” and seven “holds” with no “sells.” But these are just favorable portents, not hard evidence of the sort we’ll get March 21 when IBI announces earnings.

But we do have a growing body of evidence on recovery efforts of Enerplus and Colabor. And as I explore in the March Best Buys feature, prospects are definitely looking up for both companies.

Both companies are meeting the clear benchmarks management set out when they announced the pain of dividend cuts last year. And sooner or later, so long as they stick to that path, their share prices are headed higher.

The optimal way to deal with a dividend cut is to sell the stock before the cut is made. Identifying the most vulnerable companies, based on hard facts in the numbers, is the goal of the Dividend Watch List. And we’ve had generally good fortune over its nine-year history staying away from the endangered.

When cuts happen that you haven’t predicted it’s generally too late to avoid the initial hit. In fact selling into the momentum almost always leaves you with a much bigger loss than if you wait for things to settle down.

That may take a while, particularly with a widely held stock, as we’ve seen with Atlantic Power the past week or so. But eventually the price does settle, and at that point the questions to answer include: Why did this cut happen? Does management have a plan to engineer a recovery? And what are the benchmarks we can monitor for its recovery?

When managements cut dividends, they lose credibility with investors, and rebuilding that takes time. But so long as the company meets its benchmarks recovery is assured–both for the business and the stock.

The wise choice is to hold on so long as benchmarks are met, particularly if you’re still being paid a generous dividend.

The key is being disciplined about the benchmarks. If a company fails to meet its post-cut objectives its fortunes are not turning. In that case you may have another Yellow Media on your hands, and the best thing to do is sell. Yellow Media’s numbers did give warning it was failing, though its management did not.