Tuesday, May 6, 2014

Dividend Investing During the Financial Crisis

While stocks are going higher every day, it looks like there is not end in sight for prosperity. My net worth is in record territory, and so is my dividend income. However, I believe that somewhere down the road, we are going to experience another recession. Since the stock market is usually in a downward trend by the time the economy gets into a recession, this time of economic contraction would mean lower stock prices. As a result, I think that reviewing the lessons from the financial crisis will be helpful. This is in order to avoid panicking and doing something dumb.

The financial crisis of 2007 – 2009 was one of the darkest periods in US economic history. Millions of people lost their jobs and homes. Investors saw decrease in their net worths, as stock prices plunged. Even the relatively safe world of dividend investing was turned upside down for many. This might sound like a heresy to many fellow dividend growth investors, but there were a lot of solid companies that cut dividends during the worst of times. As a result, even investors who didn’t care about stock prices, started caring as they noticed decreased dividend checks due to dividend cuts.

New investors are often attracted to dividend investing when they hear stories about how someone with just $10,000 invested in Wal-Mart (WMT), McDonald’s (MCD) or Johnson & Johnson (JNJ) 20 – 30 years ago would be earning a lot of money in dividends, while sitting on a six-figure portfolio. In reality, not all companies that you will purchase over the span of your investing career will do as well as those three companies. On average however, if you follow a common sense dividend investing strategy that focuses on diversification, purchasing at attractive valuations, selective dividend reinvestment, and thorough analysis of companies, you should do just fine over time. The thorough analysis is important to determine if they have a chance of continuing streak of increases in the future.

Before the financial crisis, many of the dividend growth stocks you would find in the dividend champions or dividend aristocrats lists were financials. Companies like Bank of America (BAC) had been able to boost distributions at high rates, while also paying high current yields. It was all great until the start of the financial crisis. Investors who held on through the financial crisis saw income decimated. However, investors who held financials as part of a diversified portfolio that had allocation to other sectors likely saw very little in terms of dividend income decreases.

I went through the list of dividend champions for 2007 and 2008, and noted that cuts were not as extreme as I through they were:

Out of 139 Dividend Champions at the end of 2007, 11 cut dividends in 2008. Not all was bleak in 2008 however as three other companies were eliminated from the index, because they were acquired.

Out of 128 Dividend Champions at the end of 2008, 22 cut dividends in 2009. There were two companies which were acquired at nice premiums and six companies which simply froze dividends.

Unfortunately, I started my dividend growth investing in 2008, right when I launched my site. As a result, I did not invest in many financial companies other than American Capital Strategies (ACAS), State Street (STT), General Electric (GE), Toronto-Dominion Bank (TD) and M&T Bank (MTB). I would assume that a lot of income investors owned financial stocks such as Citigroup (C), Fifth Third Bank (FITB), Keybank (KEY), Synovus Financial (SNV) and Bank of America (BAC) prior to the recession. Unfortunately, most of the dividend investors I end up talking to today seem to have become converts after the financial crisis. The ones that claim to have been dividend investors before the crisis often mention only their success stories, but fail to mention their mistakes. It is usually through mistakes that smart investors learn, and adapt, before they succeed in the game of investing. I would be very interested to learn from the experiences of investors who had become dividend growth investors prior to 2006 for example.

Learning from the lessons of the financial crisis will prevent investors from losing money, sleep and sanity during the next economic correction. I learned some of the best lessons because of the mistakes I made. I was lucky in that I always tried to keep a diversified dividend portfolio. I had approximately 30 stocks by late 2008. My position in American Capital Strategies (ACAS) was mostly a current yield play. I did consider some of the banks such as Bank of America (BAC) and US Bancorp (USB), but they didn’t look appealing, despite the high yields. I did have the habit however of purchasing stocks simply based on the quantitative factors such as rising earnings, dividends and current valuation. I focused on the dividend aristocrats list, looked for streaks of consecutive dividend increases and bought the stock without reading the annual report or much in terms of any external analysis. I have since been doing a more thorough research by going through annual reports, presentations, analyst reports, analyst estimates and trying to guesstimate whether a company will last for the next 10 - 20 years and raise dividends along the way. I am also becoming more patient in acquiring stock, as I focus more on entry price than before. I am fine missing out on a dividend stock that doesn’t hit my entry criteria price, because I know I can deploy my cash in other promising stocks which are cheaper instead. I am also careful in not being mesmerized by high current yields.

Many investors know that they should not panic, even if the stocks they own fall by 50% in value, as long as fundamentals are intact and dividends are maintained and raised. In reality, investors are humans that are subject to normal emotions such as fear and greed. Even if you were emotionally prepared for a decline in your portfolio, while dividends keep getting paid, it is easy to panic and sell everything in order to stop the bleeding. Holding on to companies that remain fundamentally sound is the right course of action, although it is a difficult decision when your stock is down 50%. There is some discussion however on whether one should sell after a dividend cut or not.

Investors who held on and didn’t sell after the dividend cuts for Citigroup and Bank of America learned an expensive lesson. However, any time I read an article on why dividend cuts are not the time to sell a dividend stock, I learn about General Electric (GE) and Wells Fargo (WFC) in 2009. In hindsight buying GE in 2009 seems like a no-brainer decision. However, at the time it looked as if General Electric could go under, as the company was facing a cash crunch. As an investor, my goal is not to gamble, which is why I am perfectly fine missing out on a 200% gain, if that means I am not going to lose 100% the next time I invest. If you still disagree with my thought process, just ask the investors who bought Bank of America or Citigroup after the first dividend cuts in 2008 how their investments are doing.

I personally felt like the world was indeed coming to an end, although I kept adding the money I could afford to set aside every month to stocks. What made me fine was the fact that I had over two years’ worth of living expenses saved up in high yielding CD’s and a high yielding checking account. While buying stocks during a recession is the best time to deploy cash, one should also be realistic about the limitations of their own personal situation. During recessions, it is much more likely for a person to lose their job, and have to liquidate assets in order to survive. If you lose your job, you would not be able to find the cash to deploy at attractive valuations. Having cash come in every month in the form of dividends and interest income does alleviate some of the pain however. I was also lucky, because dividend growth investing provides you with an advantage in the markets. The advantage is that most dividend growth stocks are mature companies with stable cash flows that allow them to grow while paying a consistently growing distribution to shareholders. Those cash dividends are particularly valuable during a crisis, since it provides investors with dry powder to deploy in quality companies selling at ridiculously discounted prices.

These companies rarely get into trouble, unless there is a major change such as the internet was for newspapers and mail industry. When such companies get into trouble, the last thing they do it cut dividends. It is very rare that dividend growth companies from all industries cut dividends at the same time. During the crisis, the cuts were concentrated mostly in the financial sector. Companies like Johnson & Johnson (JNJ), Chevron (CVX) and PepsiCo (PEP) kept raising dividends. My goal as an investor is to minimize losses, while maximizing profits. I am doing this by incorporating the lessons I learned over the past six years into my strategy, and also thinking about risks of unknown in terms of probabilities. By having a plan in place, and being prepared for different scenarios, I believe that my foundation will withstand the next several cycles of boom and bust.

Full Disclosure: Long WMT, MCD, JNJ, PEP, CVX, WFC

Relevant Articles:

Should income investors give General Electric a second chance?
The Dividend Edge
The importance of yield on cost
When to sell your dividend stocks?
Is the End of Dividend Investing Coming?

6 comments:

  1. I loved that post. I started investing at from the age of 18 after receiving a considerable amount of money from my Father. Inspired not to lose it by talented celebrities who lost all their fortunes through the obvious causes I took to dividend investing. My father picked high yield shares with a dividend cover of at least 2.
    I did very well from this simple method allowing me to pay for our first house outright and still carry on investing. Then I got "clever" and listened to the "Professionals" with their ideas on growth companies and I chopped and changed to much. About 12 years ago, I almost lost the lot.
    The following couple of years I had some good performances which bailed me out.
    Then I came across Ben Graham. That started the ball rolling. Index Tracker Trusts provided a security blanket as well.
    I have now built up a portfolio of UK and US companies all of which I run through my through spreadsheet. I try to get the majority of the current share price valuation covered by the accounts so most future growth is for free.
    I came across your blog and noticed all, bar one of my US shares, you own. I now realise that I have reverted to how I started out, as a dividend growth investor, but with the advantage of technology.

    Keep up your great work.

    Best wishes

    Louis Gunn

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  2. DGI,
    I am one of those BAC shareholders who owned through the crisis. I learned a lot of lessons through that period, and still learning of course. BAC sucked me in because of the big dividend, and it ended up being to big of a position and crushed my portfolio when it tanked. I saved some face by tax-loss selling quite a lot and buying in again at the very lows. Today I'm in the green (after taking losses) and I think Moynihan has the right idea going forward. I wrote about my mistakes once before and this topped the list. But I think I may write a detailed post on BAC because it was a fast moving and confusing period and we are bound to see another event like in our lifetimes. Had I sold after the first dividend cut, it would have saved me a bundle.
    -RBD

    ReplyDelete
  3. "Many investors know that they should not panic, even if the stocks they own fall by 50% in value, as long as fundamentals are intact and dividends are maintained and raised."

    I very much enjoy reading your work and look forward to email notifications of your new articles each week. Thank you for the work you do to aid us lowly dividend growth investors striving to "get rich slowly", as the saying goes. I appreciate the heart of this article, since it is a subject that I think is on a lot our minds as the present bull market rolls on and valuations seem increasingly stretched, making fair deals in the stock market more challenging to find, and elevating the risk that investors will settle for unsatisfactory long term results by overpaying for even quality companies. The copied sentence from your article above caught my attention, since it is a statement I have seen in various other articles in different forms from time to time and, while I know from reading your previous work that your understanding of investment process is much more comprehensive than this sentence might imply as I'll point out, I thought it worth noting for the potential neophyte who might happen on this article that, as regards our understanding of price and value definitions, the sentence contains somewhat contradictory elements. Buffet has aptly noted "Price is what you pay, value is what you get"; as such, a company you own likely will not fall 50% in VALUE and maintain 'intact fundamentals and continue to raise dividends', since a widely accepted stock value metric is "the sum of future cash flows that can be taken out of a business discounted to present". But of course, throughout history, many companies have dropped 50% or more in PRICE and still amply met the value criteria in your sentence. A somewhat pedantic distinction, perhaps, but one I believe is worth making, since it emphasizes the correct way to think about the businesses we own, and correct thinking protects from foolish action, which will be especially important in the next downturn.

    ReplyDelete
  4. Are you suggesting that in addition to a limiting a position size, we should limit our portfolio's exposure to sectors?

    I suggest that we should - but some different sectors should have lower limits. EG; cyclical industries such as Oil, Financial, Mining, could see several companies cut their dividends at the same time. Other sectors such as Consumer Staples/Discretionary have a breath of product offerings and demand pool that makes it more unlikely that several companies would cut their offering at the same time. EG, it is more likely that Coke will cut their dividend then both Coke & Pepsi cut their dividend at nearly the same time. While I think it that the reverse is true for Exxon and Chevron.

    Additional, some sectors will naturally limit themselves because there are only a few companies that meet the purchase criteria. For example, I can't see tobacco becoming more than a 10% position of dividend income as each company.

    What are thoughts about limiting sector exposure?

    David

    ReplyDelete
  5. Ahh ACAS. That was one of the first dividend stocks I invested in right as the market headed south. Like you at the time, I basically read that it was a good company and invested without doing much research. I liked the idea of dividends, but didn't like the "puny" yields being offered by KO, MCD at the time. I rode that pony right on down and even bought some more as it went south. I sold it at a fairly steep loss well after they cut the dividend.

    Not the brightest moment and to this day I tend to shy away from stocks that have high yields. Although, I have found a few that I believe are solid companies after doing my due diligence.

    Take care!

    ReplyDelete
  6. Hello DGI, I have not been a DG investor for more than about four years, but before that unknowingly owned a number of DG stocks such as MO and XOM. One of the stocks I owned during the crisis was DOW, a hold-over from a position in Union Carbide and a merger. While they were not a DG stock, they had not cut their dividend in about 100 years. A combination of the financial crisis and the Rohm and Haas merger sent them into a tailspin. But I held on. After the stock had dropped about 75% or more, to around $9, they finally cut the dividend. Guess I have a strong stomach. The stock rebounded and I held on. Finally, after it gained about 20 points or so, and the dividend was more fully reinstated, I sold out and re-invested the money elsewhere. The point of this story is this: Sometimes the dividend is the last thing to be cut, as it was with DOW and sometimes it happens after the plunge. I never really liked the stock, considered it volatile, and it greatly underperformed the S&P. I should have sold it for these reasons and not waited for a dividend cut but I got sucked in because I did not have clear rules to sell a position, I didn't have a plan.. So one must be vigilant about your investments. Like the businesses you invest in, try to understand them, but if their business plan, products, prospects start to look bad, consider going elsewhere. There are too many good choices out there than to stay with a questionable holding. This is more art than science, but it can pay to keep a closer eye on positions just not performing.

    On the plus side, at the very bottom of the market, at it's lowest price, around $15, I bought more MO. Today, those shares are $40. Also, JNJ and PG held up well in a frightening market.

    Thanks for allowing anonymous posts again.

    A

    ReplyDelete

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