Wednesday, March 25, 2015

Dividend Stocks Provide Protection in Any Market






Dividends provide a positive return on investment in any market environment. Unlike capital gains, which can disappear in an instant unless the stock is sold, dividends represent a return which is realized by the investor and cannot be taken away from them. The dividend is always a positive return on investment, as evidenced by the cash deposited in investor’s brokerage account. It is also more stable than capital gains.

A cash dividend provides investors with a positive reinforcement during market declines. Bear markets as well as market volatility can make even the best investors worried about their nest eggs. Seeing the value of your portfolio fluctuate by the amount of a typical person’s annual salary every day, could be devastating to a retiree and make them question their judgment. Rash decisions such as selling your stocks, and purchasing bonds in order to limit the pain are thus much more likely especially if investors do not receive any dividends to soften the blow of stock price depreciation.

In order to reduce the psychological factors when dealing with adversity in dividend investing, there are several things that investors need to consider.

The first one is to have a strategy that fits the investor’s personality. Selecting dividend stocks provides both exposure to equities and a regular stream of income in the form of cash dividends. I can confidently predict the amount of dividend income I expect to receive in a given year - the same cannot be said about the price changes in the underlying value of my stock holdings.

The second one is that income investors should focus on analyzing companies they are purchasing in detail, and try to asses if they can continue growing. This would involve looking at ten year trends in earnings, dividends, revenues, returns on assets or equity, as well as reading a few annual reports and articles on the company in question. Having a solid understanding of the company’s business and how it generates cash flow will make it easier to stick to your guns if stock prices go down. You might even decide to add it to your portfolio if the valuation is right.

Sometimes however, no matter how well we understand the business, things outside of our control do happen. There could be change in the environment, business model or the economy, which could throw away even the best researched investment plans. In order to mitigate those risks, one needs to have a diversified portfolio of stocks. I am always amazed by the arrogance of investors who believe that a portfolio of 10 – 15 individual stocks is sufficient. They cite quotes by Buffett where he discusses how diversification is for the ignorant. I have looked at the portfolios of several traders/investors which have lost it all, and the common factor was lack of diversification. The risk that just one or two bad picks can permanently postpone your retirement is simply an unacceptable outcome in portfolio construction. Smart dividend growth investors would much rather have well-diversified portfolios with sleep well at night investments, than swing for the fences in a concentrated 10 – 15 stock portfolio. You are already retired ( or very close to that goal), so why would you even attempt to show how great of a money manager are you? It makes no sense to risk what you do need, in order to get something you might want to have but really don't need.

Another risk mitigating factor is having some firm exit rules. For example, I automatically sell an investment that cuts or eliminates dividends. I might sell at a loss, but this rule eliminates the risk of losing 100% of my investment value. While some companies increase several times after cutting dividends, others lose 95-100% of their value. If you lose 95% of your portfolio on bad investments for example, you would need to find an investment that goes up by 2000% simply to break even after that. Most investors who purchase these stocks are pure gamblers. The goal of my portfolio is to provide a dependable cash stream of dividends that grows over time, not to get rich quick overnight.

Stocks that pay dividends cushioned the losses for investors during the financial crisis. In fact, there were many companies which even boosted distributions to their shareholders:

Johnson & Johnson (JNJ), which researches and develops, manufactures, and sells various products in the health care field worldwide. It operates in three segments: Consumer, Pharmaceutical, and Medical Devices. The company paid quarterly dividend of 41.50 cents/share in 2007, raised it to 46 cents/share in 2008, and has continued increasing it all the way up to 70 cents/share in 2014. This dividend king has raised distributions for 52 years in a row. The company is attractively priced at 16.50 times forward earnings, and yields 2.70%. Check my analysis of Johnson & Johnson for more details.

Exxon Mobil Corporation (XOM), which explores for and produces crude oil and natural gas in the United States, Canada/South America, Europe, Africa, Asia, and Australia/Oceania. The company paid quarterly dividend of 35 cents/share in 2007, raised it to 40 cents/share in 2008, and has continued increasing it all the way up to 69 cents/share in 2014. This dividend champion has raised distributions for 32 years in a row. The company is overvalued at 22.40 times forward earnings, and yields 3.30%. Check my analysis of Exxon Mobil for more details.

PepsiCo, Inc. (PEP) operates as a food and beverage company worldwide. The company paid quarterly dividend of 37.50 cents/share in 2007, raised it to 42.50 cents/share in 2008, and has continued increasing it all the way up to 65.50 cents/share in 2014. This dividend champion has raised distributions for 43 years in a row. The company is slightly overvalued at 20.40 times forward earnings, and yields 2.70%. Check my analysis of PepsiCo for more details.

Altria Group, Inc. (MO), which manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. The company paid a quarterly dividends of 29 cents/share in 2008, which was raised to 32 cents/share later in the year, and has been increased all the way up to 52 cents/share by 2014.  This dividend champion has raised distributions for 45 years in a row. The company is attractively priced at 18.40 times forward earnings, and yields 4%. Check my analysis of Altria for more details on the company.

The reason why I do not track the dividend aristocrats list is because they kicked Altria out in 2008. The reason for kicking out Altria was dumb -  the company split itself in three parts, which reduced the dividend for the resulting legacy domestic US tobacco company. However, the investor in the original Altria did not really suffer in terms of total dividend income - rather they received shares in Altria, Phillip Morris International and Kraft, which together are paying much more in total dividend income than in 2007 or 2008. I am constantly surprised at the writers on Seeking Alpha who tout the dividend aristocrats index and pray that they are not really risking real money behind their work, since they obviously do not do thorough research to begin with. I have said it before, and I will say it again - the list of Dividend Champions maintained by David Fish is the most complete list of US dividend growth stocks available. The dividend aristocrats index is an incomplete list of dividend growth stocks at best.

Full Disclosure: Long all companies listed above

Related Articles:

Dividend Investing During the Financial Crisis
Where are the original Dividend Aristocrats now?
Historical changes of the S&P Dividend Aristocrats Index
The Dividend Investment Journey
S&P Dividend Aristocrats Index – An Incomplete List for Dividend Investors

6 comments:

  1. Hi DGI,

    May I ask how you determine the P/E you mention in the article? For example for JNJ you say it is 16.50 but according to google finance it is 17.88. Or is it something different?

    Thanks
    Vaclav

    ReplyDelete
    Replies
    1. Vaclav: He's looking at forward earnings rather than current earnings. JNJ is at 17.88x current (this year's) earnings, but 16.5x forward (next year's estimated) earnings. There's something to be said for both measures. You buy a stock for the future earnings it will provide you once you own it so forward earnings is very important, but they are just an estimate and that estimate may turn out to be too high or too low. At least current earnings are usually pretty solid, though on rare occasions companies do go back and restate past periods.

      Delete
  2. [quote] I have said it before, and I will say it again - the list of Dividend Champions maintained by David Fish is the most complete list of US dividend growth stocks available. The dividend aristocrats index is an incomplete list of dividend growth stocks at best.[/quote]
    Well put!

    ReplyDelete

  3. The payment of a dividend provides no special protection during a market downturn. Imagine two identical companies, Divcorp and Capgains, whose only difference is that Divcorp pays out most of its earnings as dividends, while Capgains retains its earnings. When external economic conditions induce a market crash, Divcorp's price will crash harder than Capgains's price. Of course, this doesn't make Capgains "better" than Divcorp, because Divcorp provided you with income via its dividend, and it's that dividend payment that caused its price to fall further. But it also doesn't make Divcorp better than Capgains. I agree that a dividend payment could potentially provide someone with a psychological boost that prevents from from selling during a crash, but that would be due to a cognitive error, not because Divcorp actually left them in a better financial position than Capgains

    ReplyDelete
    Replies
    1. I think Tim's point is he doesn't care if Divcorps price falls further than that of Capgains. He is unconcerned with the stock price...only it's ability to maintain its dividend payments.

      Delete
  4. Failure to understand that a dividend provides a more stable return than capital gains is the ultimate cognitive error experienced by academicians and some investors. Providing fictitious examples to prove a point is useless to someone who lives in the real world.

    A company can retain all its profits, but there is no guarantee this will lead to more earnings. If all companies have to do is retain all earnings to grow wealth to the stratosphere, why is it that there are over 100 dividend champions, and only one Berkshire Hathaway?

    Those earnings can be “priced” differently by the “market”. Those earnings could be valued at a P/E of anywhere from 5 to 35. This could either lead to feast or famine for retired investors who need to live off their nest eggs. Cash dividends will always unlock value for the shareholder.

    http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm

    If you look at S&P 500 between 1965 and 1981, you will understand what I am saying. Earnings per share tripled from $5.30 to $15.18. Yet the price went from 92.43 to 122.55. Luckily, the dividend increased from 2.83 to 6.83. The reason why the 4% rule was successful, is because stock and bond yields were high during the study period from Bengen. Dividends tracked fundamentals better than stock prices. If you lived off the dividend, you did well. If your company didn’t pay a dividend, you ran out of money and couldn’t even afford the cheapest cat food.

    If you sell assets to live off, you need rising prices above rate of withdrawal. If you need a constantly increasing price, you are leaving yourself vulnerable in the event prices do not rise for increased number of years. Only relying on stock prices is speculating. Even if earnings double in the next decade, it is quite possible that prices might not reflect it and could remain stagnant. Stock prices do not go up by 9%/year, every year. Over the next 30 years, you could have 15 years of no growth, and then 15 years of high returns to bring the returns back to average. You need to eat everyday, not only if the S&P 500 delivers a 4% total return.

    If you blindly believe that investing in an index will protect you from investor sins, you will learn expensive lessons. When you overpay for stocks your returns will suffer. If you blindly chase capital gains, your returns will suffer. If you do not understand that the amount, timing and frequency of capital gains is unpredictable, your retirement will suffer. If you have not done proper research behind each investment you have made, your returns will suffer. If you do not understand what your goals and objectives are, then your returns will suffer.

    ReplyDelete

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