Wednesday, October 7, 2009

Emotionless Dividend Investing

Investors often fall in love with stocks, which are synonymous with innovation, growth and have delivered strong total returns up to a point. It is easy to fall in love with a stock, which everyone else is touting as the next great thing, whose products you use or is one which has made many investors rich.

The main problem with such attitude however is that it could cause investors to throw their carefully researched strategies out of the window and engage in careless speculating. This could cause severe losses of capital over time.
Investors have suffered two major blows over the past decade – the tech stock crash in 2000-2002 and the financial meltdown in 2007-2008. The first occasion was a complete euphoria for anything related to technology or dot coms. College dropouts were selling stock of their money losing eyeballs attracting online ventures in IPOs, which were valued at billions by Mr. Market. Needless to say the tech boom turned into a bust that left millions of investors suffering tremendous losses. Even investors in great companies such as Microsoft (MSFT) and Intel (INTC), which were enjoying double digit revenues and earnings growth even after the meltdown, suffered huge losses because they overpaid for future growth.

The financial meltdown was characterized by investors who were holding on to safe income investments such as Bank of America (BAC), Citigroup (C) and General Electric (GE), which had a long history of consecutive dividend increases. As these stocks began their slide, they cut their distributions and had to take billions in aid from the federal government. Investors who kept a cool head and didn’t chase high yielding stocks blindly, right before they cut their dividends would have saved a lot of precious capital to be used for later.

The point being taken is that entry price paid for stocks does matter. If you mindlessly reinvest dividends or dollar cost average your way into an index fund you would end up paying top dollar for the inflated future income stream from these investments. Thus, having strict entry criteria might prevent you from chasing hot stocks and losing a lot in the process. This entry criteria could also prevent you from investing in companies, simply because you like their brand or your hope that their business would turn up for the better. Even great brands such as Johnson & Johnson (JNJ) or Procter & Gamble (PG) were not good buys when they traded at more than 20 times earnings and yielded only 1% in the early 2000s. There were other companies, which yielded much more than that and traded at lower price to earnings multiples that should have been on investors’ radars. It is better to sit in cash than overpay for stocks and then have to wait for a decade before you start generating any meaningful return on your investments.

One also needs to have a sell policy, which lets you out of a losing position no matter what. When one buys a stock because it pays a stable dividend, it does not make sense for them to hold onto the stock if the company eliminates its streak of 30 consecutive distribution increases while citing the weak economy. When you take the loss, you would start thinking more clearly. If you hope that it would turn better, you would lose money in the process. When Citigroup (C) cut its dividends for the first time on January 15, 2008 the stock closed at $26.94. Investors who sold at the time would have saved themselves from huge losses in the process.

At the end of the day, only the disciplined dividend growth investor who is careful not to overpay for stocks, and has the discipline to sell when some of his criteria are no longer intact, would be able to generate a sufficient income stream for their future needs.

Full Disclosure: Long JNJ and PG

Relevant Articles:

- General Electric (GE) Cuts the Dividend
- Bank of America (BAC) Dividend Analysis
- Reinvest Dividends Selectively
- Dollar Cost Averaging
- When to sell my dividend stocks?

5 comments:

  1. Whats your opinon about REIT's?
    For instance, CMO? They got a nice Yield.

    Check it out:
    http://finance.yahoo.com/q?s=cmo

    Regards.

    ReplyDelete
  2. So look to reinvest dividends at tactical entry points?

    ReplyDelete
  3. A couple points that I would make:

    1. The sole reason to buy a stock should not be the dividend or dividend growth.

    2. A lot of your points assume that the future can be known and your arguments cherry pick and use after-the-fact bias.

    I just bought some ADP for my wife's RRSP.

    ReplyDelete
  4. MG,

    The purpose is total return, but then the dividend income is much easier to "forecast" than annual market fluctuations.

    The point is to not have "favorite" stocks which you fall in love with, and where you ignore the fundamentals. Yes, I do prove my point by cherry picking, but then how else are you going to show your point?

    Magnus,

    I prefer investing in companies that pay a stable dividend, rather than ones whose dividend payment fluctuates.

    Anon,

    Yes, over the past few months I have reinvested my dividends selectively, and not automatically.

    ReplyDelete
  5. Absolutely agree on having a fixed selling strategy in place.

    If not you will find a number of reasons to hold on to a losing investment.

    ReplyDelete

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