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Max's Investment World Stock Market Challenge

Dividend Cuts Mean Good Things to Come

Shareholders aren't particularly thrilled when their company lowers or eliminates its dividend. After all, many people count on dividends to pay off current bills. Shareholders also think that a cut in dividends is a sign that the company will perform badly in the future and so, sell off their shares.

That's a big mistake. Researchers recently found that a company that cuts its dividend has already experienced the worst and is signaling to the world that it is on the road to recovery.

Professors at Northern Illinois University examined 268 companies from 1974 to 1989. In the two years before companies cut their dividends, earnings dropped sharply but they improved sharply two years after the dividend cut. Stock prices of such companies paralleled the trend of earnings.

But the companies didn't improve earnings after they cut dividends by boosting sales. Rather, they cut costs for materials and services in the products they sold, the professors found. While part of the cost-cutting is healthy, companies tended to purchase fewer fixed assets and spent less on research and development, which could hurt their long-term competitiveness. Moreover, these companies had difficulty cutting administrative and other costs not associated with the products they sold and many found it difficult to raise new capital to finance expansion.

Still, two years after a dividend drop, most companies in their study were healthier as indicated by improved earnings, stock price, cash positions, and lower debt.

Bottom line: if you haven't acted before a company you own stock in cuts its dividend, it's not a good idea to sell just after the cut is announced. Rather, investors should wait at least a year in the belief that the company will bolster its financial position and its stock price will improve.

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