It wasn’t long ago that a company cutting its dividend would send Leslie Lundquist into a panic. The Bissett Investment Management fund manager makes her living investing in dividend-yielding income trusts, so when one of her companies reduced its payout she couldn’t help but worry that something was amiss.

“If a company cuts its dividend, that’s a sure sign that something has gone terribly wrong,” she says. “Investors buy a company for the dividend, and if it gets cut, that admits that there’s an operational difficulty.”

That line of thinking is what guided Lundquist for years, but what do you do in a financial crisis when dividends are being cut left and right?

By February 23, 288 companies on the S&P 500 had cut or suspended their dividend — a staggering number, considering only a few businesses reduce dividends in any given quarter.

The mass reductions have put Lundquist and other fund managers and dividend-seeking investors in a tough spot: how do they know if a company’s in trouble or if it’s just following the crowd?

“It’s trickier now, no doubt,” says Lundquist. “Being income investors, we feel strongly about getting an income stream from an investment. So when we get a cut, even now, we look at the company and ask why.”

Bill Hoyt, manager of Fidelity Investments’ global dividend portfolio, says even in today’s environment it’s bad news if a company slashes its dividend. The key is finding out which business is struggling more than the others.

Understanding why a company has cut its dividend often means fund managers have to go directly to the source. Hoyt explains that his team at Fidelity speaks directly to executives, asking them probing questions as to why they’ve slashed payouts. “We can get an informed answer that way,” he says.

Like Hoyt, Lundquist also speaks to management to find out where they’re coming from. In one situation, a company who’s stock she owned caught her off guard when it cut its dividend. The company, Cathedral Energy Services Income Trust, should have been better off than its other oil and gas counterparts, as it’s a directional driller. (Directional drilling equipment makes it easier to dig to the bottom of a hole and reach areas that can’t be accessed through conventional drilling methods.)

Instead of selling it right away, Lundquist read the business’ Q4 results and met with the company to find out more information. Then she asked herself the question she always thinks about when evaluating an operation: “Did they just reduce the distribution or did they take other steps as well?” she says.

It’s a bad sign if a company only cuts, and doesn’t take other moves to improve its problems. In Cathedral’s case, they also reduced capital spending budgets for 2009. “They took a balanced approach to it. It wasn’t just an excuse to cut the distribution and blame it on the market and not make any business changes.” She feels confident that when the energy sector picks up, Cathedral will increase its dividends again.

The flow of cash

Of course, that won’t be the case for many companies battling the recession. Hoyt says the economic downturn is creating cashflow issues for many businesses, and when cashflow is volatile, so are distributions.

“Companies in good times tend to use leverage a great deal more,” he says. “The problem is [that although this] works great when things are going well, when things turn badly it makes earnings more volatile, so it puts dividends at risk.”

In these rough economic times, Hoyt is drawn to seemingly more stable companies, ones that won’t have as many cashflow issues and can bounce back easily if something does go awry.

“I’m interested in identifying high-quality companies with mature businesses that have reached a critical mass sufficient enough to allow management to say to the investing public that, ‘Yes, we believe our brand is strong globally,’” he says. “These companies can say that they’ll be able to maintain their base level of earnings and pay out investors with confidence.”

If a company won’t make reassuring statements and cuts its dividend, there’s a good chance Hoyt will sell. As for new additions to his portfolio, he says income-generating businesses have to adhere to certain criteria.

“Any new idea in the fund has to pay what we consider high-quality dividends, and there has to be some evidence that within the last 4 or 5 years the company has been growing its dividend, and cashflow has been strong in order to do that,” he explains. “It’s very challenging to find in the financial sector today, but not as much in other sectors like consumer staples or telecom.”

While these are clearly trying times among dividend-producing companies, Lundquist says investors still want their investments to generate income, and companies know they can’t just cut them because everyone else is doing it.

“It does seem more socially acceptable to reduce dividends, but at the same time boards take these things very seriously,” she says. “It brings up some really hard questions. If you’re the only bank in Canada that needs to cut its dividend it means you’re the weakest. If a company said they run a conservative business and know their shareholders bought the company for the distribution, would you really want to slash that payout in half?

“It still sends a negative message to the market,” she adds. “There is a stigma attached.”

Appeared on Canadian Business Online on March 23, 2009.

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