Shares: Payback time by those who cut the payoff

RING your stockbroker for an equity investment idea and he is unlikely to suggest piling into shares in a company that has just cut its dividend. But that in fact could be a smart move.

The classic example is ICI, which traumatised investors by cutting its dividend in the last recession. This seemingly devastating blow to its 'blue chip' status was the start of a bull run in ICI shares which took the price up nearly eight-fold over the following six years.

There are other examples from the last recession of companies cutting or passing their dividends only to see their share prices rise. These include Weir Group which passed its dividend completely in 1982. On the announcement the shares fell to 15p. They have since climbed with barely a pause to 301p. Bowater cut its dividend in 1983, and since then the share price has risen from 70p to 465p.

These remarkable performances are more understandable if you consider the implications of a dividend cut. By the time a major company is in such dire straits that it cuts its dividend, the deterioration in its trading performance has become visible to anybody taking the remotest interest. The only people left to sell may be a few income funds holding out in the hope the dividend might be held. Similarly the top managers can be in no doubt that their business strategy is not setting the world on fire. If they survive (and often they do not), they or a new team will take drastic action to cut costs, sharpen marketing and refocus the company.

Finally dividend cuts are often lagging indicators. Often, by the time the company cuts the dividend, the slump phase of the cycle is mature and the company is at, or approaching, the darkest hour before the dawn.

My interest in looking at how these shares fared in the last cycle is to draw a parallel with current circumstances. We may be a little past the perfect moment (late September 1992), but buyers should still enjoy a few years of capital appreciation from the dividend cutters.

This is where I made an amazing discovery. So far in this cycle, one in every three quoted companies has cut or passed its dividend - and that is counting only the ones that are still around. An unprecedented number have also gone bust. As far as the stock market is concerned, by any standards - including the early 1970s and maybe even the 1930s - we have been through the mother of recessions. The facile conclusion, that on my 'buy on a dividend cut' rule the stock market en masse is a buy, is probably right - the recovery potential is stunning. Nevertheless I think most investors playing this game would be well advised to stick to the big companies that have massive resources accumulated over decades and are unlikely to go bust.

Of my list of some 650 UK quoted companies that have cut or passed their dividends in this cycle, about 40 are FT-SE 100, or nearly Footsie companies. A safety- first strategy involves making a selection from this list. One near the top is Barclays. The final dividend for 1992 was cut when figures were announced in March. Since then the shares have climbed from 386p to 553p. But the likelihood is that a much bigger bull run lies ahead. Costs are being slashed and analysts are looking for earnings per share to almost double in 1994 to give a p/e of about 11 which already looks cheap.

Another that looks a good bet is British Steel. The dividend has been cut twice from 8.75p in 1990-91 to a nominal 1p for the year to 31 March 1993. But nobody has ever doubted that the group is a model of efficiency by the standards of continental rivals, and the impact on profits of a small rise in turnover is phenomenal. Analysts are looking for a return to modest profits this year and probably a surge next year. The shares have already soared from a low of 50p to 128p but there should be more to come.

Another two dividend cutting giants are British Aerospace at 399p and BP at 340p. In 1992 BP made pretax profits of pounds 112m on turnover of over pounds 33bn. On forecasts of a full-year payout of 8.4p, BP will have cut its dividend the second year running, loose shareholders will have been shaken out and management will be taking drastic action to restore profitability. Nor will oil prices fall for ever.

British Aerospace has knocked three-quarters from its dividend to just 7p against the background of a massive loss in 1992, but the shares have rallied dramatically from a low around 100p.