How Dividend Investors Can Thrive Despite Cuts

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Industrial titan General Electric (NYSE: GE) recently slashed its dividend in half, marking its second dividend cut since the financial crisis. As General Electric's previous dividend wasn't well covered, despite its long-running restructuring efforts, that cut should have come as little surprise for investors. Still, for those who don't regularly monitor their holdings -- particularly for those that rely on dividends for a significant portion of their income -- cuts like that can drive two types of pain.

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To start, the cut directly reduces the dividend income that the shareholder receives. Additionally -- as happened with General Electric -- such cuts typically bring with them reductions in the company's share price.

As dividends are not guaranteed payments, cuts are a risk that investors face. While you might not avoid all dividend cuts in your portfolio, you can arrange things to reduce the impact they have on your overall financial well-being.

First, diversify your holdings

As the longest-running member of the Dow Jones Industrial Average and one that used to sport a top tier AAA credit rating, General Electric is no fly-by-night business. That it could suffer to the point where it was forced to cut its dividend twice within a decade should make it clear that any company could suffer a similar fate. As a result, if you're looking for dividend income from your portfolio, you should make sure your ability to cover your bills is not tied to one company or industry.

By diversifying intelligently, you can reduce the risk to your overall portfolio from the stumbles of any one company within it. It's not enough to blindly buy random companies; each individual pick in your portfolio should be worthy of owning on its own. By looking for worthwhile companies across industries and allotting no more than around 5% of your portfolio to any one position, you can reduce the impact that one troubled business has on your income or net worth.

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Next, look for potential growth

The key advantage of dividends over interest payments is the fact that dividends have the potential to grow over time as the earnings of the companies that pay them grow, too. A growing dividend can help you keep up with inflation. In addition, growing dividends elsewhere in your diversified portfolio can help make up for a company that cut its dividend.

Yet not every company that pays dividends will increase them. While there are no guarantees that a company will increase its dividend, there are a few signs you can look for to improve your chances that a company you're investing in just may do so for you:

  • History of dividend increases. If a company has a pattern of increasing its dividend, chances are it will want to continue that pattern.
  • Reasonable payout ratio. A company can only continue to pay dividends if it has the cash-generating capacity to do so. For most companies, look for a payout ratio below 70% earnings, though partnerships and real estate investment trusts may pay out at higher levels.
  • Decent expected earnings growth. Since a company has to earn money before it can pay it out to its shareholders as a dividend, the only sustainable dividend growth comes from earnings growth. Look not only for a positive earnings growth projection, but the drivers behind that projection as well, to help assure they look realistic.
  • Solid balance sheet. When times get tough, companies with weak financial foundations will be more likely to cut their dividends to protect their operations. A solid balance sheet can help a company maintain its payout through temporary tough patches. The combination of a debt-to-equity ratio below 2.0, a current ratio above 0.5, and enough cash on hand to cover everyday operations generally provides a decent foundation.

Finally, don't rely on dividends directly for your spending money

As tempting as it may be to simply spend your dividend income, the reality is that you should not depend on stocks for money you need to spend within the next five years. Instead, consider your dividends as part of the money you have available to extend your bond ladder or otherwise balance your portfolio between stocks and bonds.

That way, even if something terrible happens and your overall dividend income drops substantially, you're not directly depending on those dividends to make ends meet. It won't eliminate the impact of the smaller dividend or the likely loss of stock price value, but it will give you time to adapt and time for your portfolio to recover. When it comes to successful investing, a long-term time horizon is the key tool to help you thrive, no matter what the market is doing in the short run.

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Chuck Saletta owns shares of General Electric and has written a December 2017 $24 call option against his shares. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.