The dividend signaling theory states that a firm increasing or decreasing a dividend is signaling to the world its future prospects. Since management has better insight into the company’s fortunes than the general public, its dividend policy, over and above other public disclosure, truly indicates where the company is going.

Would it not stand to reason then that, if you are a believer in the dividend signaling theory (which is a hotly contested theory among economists), a dividend decrease is a signal that the company has a pessimistic view of its near term financial future?

Not necessarily. A 2005 study published by Eric Lie in the Journal of Corporate Finance examined 661 dividend decreases and 484 dividend omissions in the period of 1980-1998 (or during two full blown recessions) and found the following major findings:

1. Companies tend to perform better or the same after a dividend decrease or omission- but not worse. This seems logical if you consider that the company has decreased or omitted a dividend for the purpose of freeing up cash to keep the business afloat.
2. Companies that decrease dividends tend to exhibit normal performance after the announcement. Most likely for the same reason discussed above. The study found that a business that omits a dividend typically takes 2 quarters to return to normal business performance.
3. The market reacts negatively in the quarter leading up to the dividend decrease or omission, neutral in the quarter of the announcement and positively to earnings announcements thereafter. This also seems logical since dividends follow earnings and earning decreases are typically accompanied by stock price decreases. The author concludes given how the market reacts positively in the quarters after the dividend cut, the markets tend to over-react when the dividend decrease was announced.

The paper does not address if dividends are increased after a decrease or omission. Most of the research was focused on earnings subsequent to dividend decreases or omissions. However, if dividends follow earnings, there may be (emphasis on “may”) ground to believe that dividends could be restored after a period of time.

The entire paper can be found here (as an interesting aside, the author did attempt to create a methodology to account for survivorship bias and, while admitting it is still a possibility, asserted that the findings were not affected by this).

There’s has been a debate about possible actions if a company cuts its dividends.  Arguments have been made that a dividend investor should sell out of any company that cuts it dividends. I don’t have any hard and fast rules if a company cuts its dividend; you have to take it case by case and industry by industry.

If the entire industry as a whole is slashing dividends, it is troubling because it could be nothing more than a prelude to a race to the bottom. If there are one or two laggards in a dividend paying industry cutting dividends then competitive pressures may force the company to eventually restore the dividend; the best example being TransCanada cutting its dividend in the 90′s due to short-terms business issues and steadily increasing the dividend in order to remain competitive with its dividend paying competitors (mostly notably, Enbridge).

I would like to see Lie update this piece after the dust of this downturn settles. But, if nothing else, Lie’s work seems to suggest that, historically speaking, a dividend cut or omission (a more dramatic move) tends to signal a near bottoming or bottom and a return to normalcy for the business operations.