Tuesday, September 30, 2008

Which Bank will be next? Follow the dividend cuts

I received a lot of e-mails from subscribers on Monday after the collapse of Wachovia, asking me which bank I believe will be the next to fail. Most investors are afraid they will wake up next Monday morning with a worthless financial stock, whose deposits have been sold to another institution.

I think that the answer to that question is to simply follow the money. Most of the financial institutions which ended up with stock prices rapidly approaching gravity were in terrible financial condition and as a result their management scrambled to find ways to fund the ongoing operations and cut expenses to the bone. One of the most difficult decisions that most boards had to make was cut the dividends.

Typically most US companies pride themselves for having an uninterrupted record of paying dividends or even better, a long period of uninterrupted increases in their annual payments to stockholders. Thus cutting the dividends to shareholders is usually one of the last resorts to action.

If you look at the records of the financial institutions in the S&P 500 that cut their payments this year, you will find an interesting pattern of dividend cuts and then massive failures. Examples like this include FNM, FRE, LEH, WB and WM. In most cases the dividend cut gave shareholders a warning signal at least several months before the failure. Just for the record this strategy isn’t foolproof so don’t bet the bank on it – there will surely be financials which cut their dividends and most probably prosper in the coming good times. It would be interesting to note how the companies in this list perform over the next few years.

So should you be worried about the next bank failure? I think that as long as your portfolio is well diversified you shouldn’t worry too much about day to day news but focus on the big picture and your long term financial goals. Historically it has paid off well to pick up distressed assets at bargain prices during bear markets. In addition to that dollar cost averaging your way into a position is the perfect strategy in a bear market. Check this chart out for the average durations of previous bear markets for reference as well.

Full Disclosure: I do not have any positions in the companies mentioned in this article.

Relevant Articles:

- Dollar Cost Averaging
- Average Durations of Previous Bear Markets
- My Dividend Growth Plan - Diversification
- When to sell your dividend stocks? Part 2

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