<THE FOOLISH FOUR>

When Dividends are Cut
by Bob Price
(TMF Sandy)

Houston, TX (November 3, 1998) -- First, to those who read last Tuesday's column right after it went up, my apologies. There was a mix-up in editing, and it didn't make sense as first posted. The Foolish way, of course, is to fix these things as soon as we see them. We did, but not before several e-mails appeared indicating the mistake. The one expressing the problem most effectively concluded: "I'm not sure what you were trying to say -- but there are people out there who will now be convinced that they can never understand the stock market."

Ouch!

If you were one of the confused, please read it again.

Even with the corrections, I'm not entirely happy with the last column. The concept of the dividend limiting downside risk is one that deserves full attention from Foolish Four investors.

One reader "cut" to the heart of the question by asking how likely it is that the dividend of the highest yielding stock will get cut. The question not asked was, "and how much will it hurt?" To answer this question I trolled through the Dow Dividend Spreadsheet looking for #1 yielding stocks (as of January 2 each year) that cut their dividends in the following year.

I found 9 such cases in the 37 years that the spreadsheet covers (1961-1997). So the answer to the first question is 24%. Call it 1 chance in 4, although the sample size is too small for that to be more than a ballpark estimate.

(Speaking of ballparks, yield is a kind of "level playing field" way of looking at dividends. Yield = dividend/price. Think of it as the interest rate the stock pays, as opposed to the actual dollar amount of the dividend. It lets you compare the dividend with what it costs you to get the dividend.)

For the unasked but important question of how much it will hurt, let's look at each case. Returns quoted below are for total return (price appreciation plus dividends).

[NOTE: If you aren't familiar with how we pick stocks for the Foolish Four and the RP variation, bear in mind that the highest yielding stock will be excluded from a Foolish Four portfolio when it is also the lowest priced of the 10 highest yielders. The RP method will automatically exclude any stock that is both the highest yielding and lowest priced stock, as well.]

Highest yielding Dow stocks that cut their dividend, 1961-1997

Bethlehem Steel <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BS)") else Response.Write("(NYSE: BS)") end if %> was the high yielding stock at the start of 1962, but not the lowest priced. They cut the dividend near the end of the year and ended the year down 27%. This hurt the returns of the Foolish Four, but the RP method avoided it because BS was the number-one ranked RP stock.

In 1971, Anaconda was the highest yielder. They cut their dividend for the first two quarters of 1971 and eliminated it for the rest of the year. The Foolish Four and RP avoided Anaconda because it was also the lowest priced stock. That turned out to be a good move, since Anaconda was down nearly 22%.

In 1975, Chrysler <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: C)") else Response.Write("(NYSE: C)") end if %> was the highest yielder and lowest priced stock and was not picked up by the Foolish Four or the RP. Chrysler totally eliminated their dividend and paid out $0.00 yet ended the year up significantly -- over 40%. That wasn't good enough. It still underperformed the market that year. The Dow was up 44%. (1975 was a recovery year following the recession of 1973-74.) The Foolish Four and RP would actually have had slightly lower returns if they had included it.

In 1978, Chrysler was again the highest yielder and lowest priced stock. They dropped their dividend in the last quarter. The Foolish Four and RP benefited from excluding Chrysler, because it ended the year down over 19%.

In 1982, Manville Corp. was the highest yielder and lowest priced stock. It filed Chapter 9 bankruptcy, ceased paying any dividend during the year, and ended down 21%. The Foolish Four and RP avoided the stock.

In 1987, Texaco <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TX)") else Response.Write("(NYSE: TX)") end if %> was the highest yielder but not the lowest priced stock. Both the Foolish Four and the RP picked it. After legal problems, it entered chapter 11 and ceased paying a dividend. In spite of this, it was up 3% that year and actually benefited the Foolish Four portfolio because the alternate stock (Allied Signal) was down 19%.

Now for an astonishing case. In 1991, Goodyear Tire <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GT)") else Response.Write("(NYSE: GT)") end if %> was the highest yielder (but not the lowest priced stock). It cut its dividend substantially that year, yet the return on GT that year was over 182%. You read that right -- the stock nearly tripled your money in one year. The Foolish Four benefited, but the RP skipped the stock because even though it wasn't the lowest priced stock, the combination of price and yield still put it at the top of the RP's list.

In 1992, Westinghouse <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WX)") else Response.Write("(NYSE: WX)") end if %> cut its 35 cent dividend to 18 cents. It was both the highest yielding and lowest priced stock, so the Foolish Four and RP both avoided it. Good thing -- it lost over 20% for the year.

In 1993, IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> was #1 on our high-yield hit parade. It was not cheap, though, so the Foolish Four avoided it, although the RP picked it. IBM cut its dividend and returned over 18%.

So 24% of the time, the highest yielding stock did, in fact, cut its dividend -- often, but not always, with disastrous results. In every disaster but one, however, the Foolish Four's protective mechanism (skip the lowest priced stock when it is also the highest yielder) acted to keep the Foolish Four out of the stocks that lost money. The RP avoided all of the losing years.

Fool on!

Current Dow Order | 1998 Dow Returns

11/03/98 Close

Stock Change Last -------------------- UK +2 5/8 42.63 IP + 3/4 45.94 MO +1 53.00 EK -1 15/16 75.94

Day Month Year FOOL-4 +1.54% 2.26% 13.41% DJIA +0.00% 1.33% 10.09% S&P 500 -0.07% 1.11% 14.47% NASDAQ -0.69% 0.96% 13.89% Rec'd # Security In At Now Change 12/31/97 206 Eastman Ko 60.56 75.94 25.39% 12/31/97 276 Philip Mor 45.25 53.00 17.13% 12/31/97 289 Int'l Pape 43.13 45.94 6.52% 12/31/97 291 Union Carb 42.94 42.63 -0.73% Rec'd # Security In At Value Change 12/31/97 206 Eastman Ko 12475.88 15643.13 $3167.25 12/31/97 276 Philip Mor 12489.00 14628.00 $2139.00 12/31/97 289 Int'l Pape 12463.13 13275.94 $812.81 12/31/97 291 Union Carb 12494.81 12403.88 -$90.94 CASH $754.73 TOTAL $56705.67