Monday, August 12, 2013

How to define risk in dividend paying stocks?

For many equity investors these days, risk is usually defined as an unfavorable fluctuation in stock prices. This means that an investor who purchased Coca-Cola (KO) at $40/share, and observes the price decline to $30/share, had a $10 unfavorable move in the price against them. This view on risk could be adequate for investors whose investing timeframe is in days or months. The problem with defining risk with stock market volatility however, does not make much sense for long-term investors.

As a long-term investor, I focus on identifying companies with strong fundamentals, and good business prospects, which I then try to accumulate at attractive valuations. I then monitor long-term business trends, read annual reports, and check to see if the company is earning more and paying out more in dividends. As a result, the data points I use are in “years”, rather than days or months. If you expect to hold a company for 20 years, focusing on a decrease from $40 to $30 is relatively immaterial. In my investing, I usually avoid focusing on price fluctuations, except as a tool to uncover cheap stocks to buy. Of course, if this drop is because of some material information that could affect the long-term prospects of the business, you need to evaluate whether you want to add or liquidate your position. However, if this drop is because stock prices are simply going down in tandem, chances are that you are not getting much from this information.

For me, risk is defined as a situation where I lose my all of investment capital. When I lose my investment capital, I would be unable to make more investments and earn more money from it. This permanent loss of capital is usually associated with situations such as business failure from the company I invested in. This would mean that not only would I lose out on a portion of my dividend income, but would also be unable to replace it because the capital base has dwindled significantly. This is why it is important to diversify my investments, in order to reduce the impact on my capital base from the effects of one company failing. If the stock I own merely goes from $40 to $30, but the fundamentals are unchanged I would not see that as a risk, but rather as the cost of doing business. Therefore, deteriorating fundamentals are a much larger risk to your capital and dividends than stock price fluctuations alone.

I believe that prices are what you pay, but value is what you get. Over the next 20 - 30 years that you hold dividend paying stocks, you will likely suffer big declines in stock prices on several occasions. This could be due to a lot of factors like recessions, wars, oil shocks, as well as a lot of company specific factors. The goal is to start with the facts first, such as a news release or an annual report for example, rather than focus on prices alone, and avoid making decision on rumors and opinions which are not grounded by facts. It is also important to be mentally prepared for declines in prices, and not panic and do something stupid like selling everything.

I would consider selling only after a dividend cut, in order to avoid acting on noise. The reason behind this rule is two-fold. The first reason is that companies do not grow to the sky in a straight-line. There are roadblocks along the way. At the time these roadblocks occur, it is very difficult to evaluate if they will result in a permanent loss or not. When Johnson & Johnson (JNJ) had issues in one of its subsidiaries in 2010, many investors feared the worst. Since then however, the company has managed to clean up operations, and succeeded. If you had sold back then, you would have missed out on the opportunity. As a result, any negative news might be scary at the time, but in the grand scheme of things, could be simply considered noise. This is why I note these negative events, but might refrain from selling off my position. I have also sold when I found valuation to be too high, but I have had mixed results from this scenario.

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

Relevant Articles:

Dividend investing timeframes- what's your holding period?
Dividend Investors Should Focus on Valuation, not Just Dividend Yield
Opportunity Costs for Dividend Investors
High Yield Dividend Investing Misconceptions
Replacing dividend stocks sold

This article was featured in the Carnival of Personal Finance, Back to School Edition

5 comments:

  1. Thanks for the nice article. Do you regard a dividend cut the same as a dividend freeze?

    Best regards!

    ReplyDelete
  2. Enjoying your blog. For the investor who doesn't have the time to devote or trusts their emotions when balancing a lot of stocks - do you recommend a fund like Vanguard Dividend Growth with reinvested dividends? I am thinking particularly about trusts set up for grandkids.

    ReplyDelete
  3. Robin,

    I am fine with a dividend freeze. IT simply means i hold on to the stock but would not add any money to it. If it cuts however, I am out. I don't pretend to know when a cut will happen - many claim they foresaw cuts, but I strongly doubt that is the truth. Thanks for stopping by.

    Anon,

    You know, I am usually against ETFs and mutual funds based on dividends. I think that you can easily set up a portfolio of 30 -40 names, and have the trust hold on dearly to these stocks. You might decide to sell after a cut, or you might decide to simply hold on and never sell ( but distribute dividend income annually). There is a mutual fund started in 1930's in the US, which never sold, and which has outperformed the S&P 500 for about 80 years. So much for outsmarting the market.

    ReplyDelete
  4. Risk is not volatility, but loss of capital. Upside volatility is good. The most serious risk is permanent loss of capital, such as due to corporate bankruptcy, which is why safety and diversification are paramount. While less serious, temporary loss of capital is not immaterial as this article may suggest, because by buying KO at $40, you have lost the opportunity to buy a lot more of it at $30.

    I beg to differ on selling on a dividend cut. That is almost always the wrong decision for quality dividend stocks. By the time the dividend cut becomes news, the market has already priced it in and sent the stock to the bargain basement. When GE and WFC cut dividend in early 2009, it was great time to buy, not sell, giving you a 700% return. When a long time dividend payer cuts its dividend, it is typically due to a temporary setback, and it will do everything in its power to restore the dividend when things return to the norm.

    ReplyDelete
  5. Volatility is not risk. When I buy a share of KO, I buy a share ownership of an actual business not some lottery ticket. I don’t care about fluctuations, as long as business fundamentals are fine. If I buy at 40, there is no way of knowing that it goes to $30 or $50 or whatever next. What you are describing is speculation, not sound investment. Why would I care if price is down to $30? The question to ask is whether this is a good business whose economic prospects will remain intact, so it can deliver profits, dividends and sales for 20 years.
    The second comment you make is plain wrong. This is because you are cherry picking your examples to fit your point. What about Citigroup or BOA? What you should be doing is looking across the universe of all dividend cuts and then decide what makes sense. Your dividend cut company either recovers and does pretty well, or it goes under taking your money with it. I have discussed that hundreds of times on this site – please do some homework before commenting.

    ReplyDelete

Questions or comments? You can reach out to me at my website address name at gmail dot com.

Popular Posts