Second, in my analysis of companies, I have noted that when a company cuts dividends after it has paid and increased them for decades, it is usually admitting trouble. However, there is more trouble ahead, because boards typically make their decisions on whether to increase or cut distributions based on the business prospects for the next 2 – 3 years. In the Johnson & Johnson case above, the company was experiencing some issues, however they kept raising the dividend and kept earning more per share. This indicated that the problems are not as huge as expected.
Of course, selling after a dividend cut is not effective 100% of the time. However, it is a fail-safe mechanism, that can allow an investor to have a reasonable confidence that selling at this event will leave them with some capital. This capital can then be deployed in other attractive opportunities that will generate rising streams of income. In addition, selling after a cut removes any guesswork of whether the negative events you are learning about the company are noise or not. It should also be a wake-up call for the investor who “falls in love” with a company, and could expect to rationalize themselves out of selling a company with deteriorating fundamentals.
In conclusion, I define risk in dividend investing as an event that leads to total destruction of capital, from which my dividend income would be reduces or eliminated. In order to reduce this risk, I am diversifying my portfolio, and have a hard sell rule of disposing of a stock after a dividend cut. This would protect my dividend income, and allow me to enjoy the fruits of my labor in my golden years.
Full Disclosure: Long KO and JNJ