Yesterday, one of the shares in my portfolio was subject to a cut in its dividends and thus a reduction in its dividend yield.

If the reason that you are holding these shares is because of their high dividend yield, as it is for me, then this is obviously bad news.

In this post, I will examine why companies cut their dividends and correspondingly, their dividend yield and what this means for the dividend investor.

Dividends and Dividend Yield

As explained in a previous article, dividends are payments made by a company to its shareholders, similar to a bank paying interest on your savings.

The dividend yield is therefore what you get back each year, in return for what you invest.

The higher the dividend yield, the more cash you get back each year.

It therefore works like an annual savings rate for a savings account.

The dividend yield is just the way that dividend investors express the dividend they receive each year.

RSA Insurance (RSA)

Yesterday, Royal and Sun Alliance Insurance (RSA) released its preliminary results to the stock market.

In those results, RSA announced that it was cutting its final dividend by 33% from the 5.82p per share it paid out at this time last year, to 3.9p now.

Not only that, but it signaled that it was going to be cutting the next interim dividend by the same 33% too.

This dividend cut is not consistent with the rising dividends that has been RSA’s dividend policy for the last 10 years.

So why did the company decide to cut its dividend payment now and what will happen as a result?

Reasons For Cutting Dividends

To understand why the company directors have changed their dividend policy and risked damaging investor confidence, we need to look at the latest results announcement for their reasoning.

Making the decision to cut dividend payouts is never an easy decision for the company’s board of directors to take.

It is therefore normal to find an explanation of why they have done it in the Chairman’s or Chief Executive’s statement given at the front of the results announcement and annual report.

Looking at this for RSA, we see several reasons why they felt the need to cut their dividends now:

  1. Profits have fallen 20% during the last year.
  2. Higher insurance payouts than expected this year were caused by Hurricane Sandy, the Costa Concordia cruise ship disaster and UK floods caused by the wettest year on record.
  3. The company sees growth opportunities with bolt-on acquisitions outside of the UK and needs the cash to invest in these.
  4. The company has been paying out £200m of cash every year since 2008 in the form of dividends and now feels that this is constraining the growth of the business.
  5. The returns from the company’s investments have been falling in recent years due to the yields on its bond investments that have fallen to an all-time low and the company sees no sign of this changing any time soon.

In summary then, the board feels that it is in the best interest of its long-term shareholders to re-base its dividend policy at a level 33% below where it was before to free up extra cash for growing the business.

How Did The Stock Market React?

As you might guess, the share price for RSA fell yesterday on hearing the news for the first time.

The shares fell more than 13%, essentially because the cut in dividend was unexpected news.

Had the cut been suspected by stock market broker analysts or signaled in advance, like the next interim dividend, then the share price would not have dropped much yesterday as it would have fallen already.

This is what is meant by the “news already being in the share price” or not in this case.

When new news hits the stock market, you can usually expect the share price to be affected.

What Will Happen To The Share Price Now?

Previous to this announcement, RSA was yielding something like 7% and its high dividend yield was the major attraction to holding the shares.

It is perhaps not surprising then that the shares fell 13% yesterday as investors who were holding the shares for this reason alone decided to sell out or reduce their holdings.

After the dividend cuts and fall in share price, the future dividend yield will be more like 5.2%, which is still relatively high.

As a result, dividend investors will not be put off completely by this announcement in my opinion and so a lot of the fall yesterday was probably due to the initial shock of hearing the announcement.

If you believe what the company management say, then we can expect the dividend to rise gently again from this time next year onwards.

We should also expect to see management investing more into the company via bolt-on acquisitions.

If they deliver on this promise, then this particular dividend cut could prove to be a blessing in disguise for investors!

What do you think will happen next?  Will the dividends rise from this new base?  Will the share price rise or fall? Leave me a comment below…