Wednesday, September 25, 2013

Long Term Dividend Growth Investing

The only thing that is constant in life is change. The world of dividend investing closely follows this eternal truth as well. For example, in the past two decades investors have witnessed several implosions in large companies that have previously been considered blue chip stocks. Companies such as AT&T Corp had mostly lost its status as a widows and orphans stock after the split in 1984, cut dividends in 2001, and was eventually purchased by SBC Communication in 2005. SBC Communications took the AT&T name after that.

Another example includes financial institutions such as Bank of America (BAC), Citigroup (C ), Wachovia and US Bancorp (USB) which were regarded as safe blue-chips by investors for many years. These companies managed to boost distributions for several decades, and could be found on the dividend aristocrats lists. In fact, these companies exemplified the characteristics of the perfect dividend growth stocks, since they not only provided high yields but also grew distributions at above average rates. While the financial crisis of 2007 -2009 proved that this was all based on financial alchemy, investors who sold after dividend cuts and reinvested proceeds in other income producing securities did fairly well.

Even stodgy utilities, which investors regard as safe investments could deliver their fair share of losses. For example, in 1974 Con Edison (ED) skipped dividends for one quarter and then initiated them back at a rate that was 55% lower than prior to the cut. This was prompted by the fact that the company used oil for its power generation facilities, and the oil embargo made it unable to pass price increases to consumers quickly enough. In addition, it was burdened by construction projects used to increase capacity, all of which caused a shortage of cash. This probably surprised many investors, who were relying on dividends of otherwise stable utilities. In fact, when I look at records of utilities companies in the Dow Jones Utilities Index, there are just a few that have never cut dividends. This goes on to show, that time and again, dividend investors might fall in love with a certain sector, be it master limited partnerships, financials, consumer staples or real estate investment trusts. If they are not careful however, and overexpose themselves to certain sectors, they increase the riskiness of their portfolios.

In essence, there are no perfectly safe investments. While a company looks perfectly stable today, and poised to grow forever, the reasons why it would implode might not be known for several decades. As a result, buy and hold dividend investors should regularly monitor the companies they own and devise a plan to sell if a certain trigger event occurs. For example, I would automatically sell a stock after it cuts distributions. I would then reinvest capital in a company in a similar industry. My experience has uncovered that companies that admit they no longer can afford to pay distributions are very risky. Essentially these stocks either go to zero after cutting dividends, or deliver stratospheric returns after that, with equal chances of either outcome. However, by retaining flexibility to sell after a cut, an investor saves their portfolio for another day. By reinvesting into another company, the investor also recoups a portion of the lost income. If the dividend cutter eventually starts raising distributions again, you can always get back in.

As a dividend investor, I would expect that names in my portfolio in 2042 would likely be different than the names present in 2012. After all, since 2008 I have experienced several cuts in my income portfolio. I had one cut in 2008 (ACAS), two cuts in 2009 (GE, STT), one cut in 2010 (BP) and no cuts in 2011 and 2012.  With three months to go in 2013, I have not experienced any dividend cuts either. By maintaining a relatively diversified portfolio consisting of over 40 individual issues, my total dividend income is somewhat immune by dividend cuts or eliminations. If two companies in an equally weighted portfolio of 40 issues completely eliminate dividends but the remaining 38 issues raise distributions by 5%, my dividend income would be unchanged for the year. Assuming that I manage to replace the fallen dividends stocks I sold with fresh income stocks, I might even be able to eke out a gain in total dividend income. Monitoring 40 – 50 positions should not take a lot of time as well. Assuming that investors have done their homework in the initial stage, future time could be allocated reading annual reports and maybe quarterly reports while also performing an annual checkup of their position. I would not expect this to take more than 10 -15 hours/week.

After all, a company like McDonald’s (MCD) would keep being in the restaurant business for as long as possible. Its business model of delivering a consistent customer experience on a global scale should not change much. Its expansion might come not just by opening new stores internationally however, but by renovating existing locations, innovations in its menu and attracting new customers from a young age. These megatrends do not happen overnight, and would likely take years to develop. Another example includes Wal-Mart (WMT), which is the world’s largest retailer. While the company has largely saturated US market, it could grow substantially abroad. In addition, it could also grow organically by making stores more appealing to consumers. At the same time, if investors use the company’s product or service in their everyday lives, they might gain an insider’s look at things, even before the annual reports are out.

Full Disclosure: Long ED, MCD and WMT

Relevant Articles:

Six things I learned from the financial crisis
Dividend Investors – Do not forget about total returns
How long does it take to manage a dividend portfolio
- Buy and Hold means Buy and Monitor

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