Since 2008, when the Federal Reserve slashed interest rates close to zero and then kept them there indefinitely, dividend-paying stocks have become one of the most effective ways to earn a guaranteed rate of interest that amounts to more than peanuts. As of March 22, 2021, bank investments such as money markets and certificates of deposit (CDs), which used to be good for at least a 5% rate of return, still pay significantly less. The going rate is now about 0.06% for money markets and 12-month CDs are paying 0.14%. Dividend stocks, however, can pay up to 5%, in some cases.
Why Investors Choose Dividend Stocks
For an investor looking to receive steady interest payments on $10,000, dividend-paying stocks are the obvious solution. By locating a company that pays a 5% dividend, the investor can receive a quarterly dividend check for $125, and he gains on any increase in the stock itself. With a CD paying 1%, by contrast, his quarterly interest is a measly $25, and he has no additional way to earn money on the investment.
The challenge comes when a company suspends its dividend, which is not a rare phenomenon. For an investor who chose a stock primarily for the dividend, a suspension of this benefit poses a conundrum of whether to sell the shares. The most prudent way to make this decision is to determine why the company is suspending its dividend and the investor's motivation for holding the stock.
The Reason for the Suspension
Companies suspend dividends for different reasons. Sometimes it is a cash flow issue, which is a legitimate cause for concern for investors. Other times, the company wishes to redirect this money into a growth opportunity, such as acquiring a competitor or expanding into a new market.
A dividend suspension is almost always accompanied by a press release. It is worth an investor's time to read it and try to understand the specific reason why the company is suspending its dividend. The people who write these reports are masters of spin, and they tend to obscure information that might lead investors to believe the stock is headed for a fall. If the press release does not clearly and explicitly state a logical reason for the suspension, it may be time to dump the stock.
On the other hand, a press release that clearly lays out a growth plan for the company may indicate the stock is worth holding onto, even if the dividend income it provided temporarily disappears.
The Investor's Motivation
Investors choose dividend stocks for their guaranteed regular income, but often, that is not their only motivation. If a stock has a good growth outlook and is well-positioned to offer strong returns in the near future, a dividend suspension may not be a good reason to sell. Dividends effectively add to a stock's returns; a stock generating 12% annual returns and paying a 3% dividend has effective annual returns of 15%. An investor who projects a stock to grow at 20% over the next year should not dump it just because the company suspends a 3% dividend. Even without the dividend, the stock is beating the market, and an equal or better substitute is difficult to find.
Alexander Rupert, CFP®
Sequoia Financial Group, Cleveland, OH
If a company cuts their dividend or eliminates it altogether, investors should first find out why. Analyzing the company's financial statements and press releases is a good place to start. The reason for the cut could be negative, such as difficulty maintaining earnings. The reason could also be positive, like plans to invest in a new project that will hopefully generate future value.
Whether or not you sell the stock in response depends on your investment strategy. If you own stock primarily for income, selling may be a good option. If you are investing in the stock for absolute return, then you shouldn’t be solely concerned with its dividend payments, the focus should be on the long-term financial health of the company.