Wednesday, August 26, 2015

Do not get emotionally attached to a dividend position

As someone who has been investing in, and writing about dividend paying companies for over seven years, I have accumulated a lot of observations about investor behavior. One of the issues I have observed is when investors get emotionally attached to a dividend stock they owned. While it is important to invest in companies you understand and believe in, it is equally important to also know when a company is no longer performing up to par. It is important to objectively evaluate and identify companies in a portfolio that are no longer pulling their weight, in order to stop adding to those companies and possibly even sell them. Failure to do so could result in permanent loss in capital, and permanent loss in capacity to generate dividend income.

Many investors I have interacted with over the years have liked the types of Johnson & Johnson (JNJ), Procter & Gamble (PG), Coca-Cola (KO) to name a few examples of successful dividend growth stocks from the past few decades. And I agree that these companies are great, with wide moats, strong competitive positions and global platforms for selling branded products at a premium price. However, while these companies are great there is not such a thing as a buy and forget investment.

It is important to monitor your dividend stocks regularly. Monitoring is important, because things change and people cannot predict what will happen to a business 20 years from now, using the information of the past or present. A healthy and growing company today might find itself in a declining industry and have its fortunes decimated. Investors should purchase stocks with the intention of holding on for the long run. However, if any warning signs are spotted investors should not add more funds to position, and even consider selling. Newspapers enjoyed an economic moat for decades. The internet ruined the moat of companies like Gannett (GCI). Other companies might decide to change business model and embrace hot growth industries, while disposing of their core stable cash generating assets in the process. Prime case in point is Enron. Another one was french water utility Vivendi, which turned itself into a media conglomerate.

For example, I see Procter & Gamble (PG) as a stock to hold forever, until I see evidence that I am wrong. If the company's position deteriorates to the point that it cuts dividends, I would be selling the stock and replacing it with another attractively valued dividend stock the minute after the facts are communicated via a press release. When a company has not managed to grow earnings for several years in a row, and dividend growth is running on fumes ( meaning that the growth in dividends is accomplished only through expansion of the dividend payout ratio), I stop adding to that stock.

The risk with investing is that few can forecast things that have never happened, before they actually happened. As a result, while I am very much liking Procter & Gamble’s business model, and the fact that almost all households in the US have at least one of its product, I am keeping an open mind about the stock. The problem with the company is that over the past 6 years it has been unable to earn more than the $4.26/share it earned in fiscal year 2009.  The dividend has been adequately covered, but most of the growth since 2009 has been through expanding the dividend payout ratio. This is unsustainable, and would likely result in a halt to future dividend growth in the near future. As a result, I have not added to my position in Procter & Gamble since early 2013.

At the end of the day, what matters are facts about the business you own, not your emotions, hopes and wishes. Buy and hold means buy and monitor, not buy and hope. If you fail to objectively monitor your positions, any deterioration you might see in fundamentals could be costly for your retirement. If you also keep hoping that things would get better, despite evidence to the contrary, chances are this could cost you a lot. As a result, I have personally decided as a hard and fast rule to sell immediately after a dividend cut. This rule is to protect me from myself. Do you believe that you will be able to successfully forecast deterioration in fundamentals in advance? I don't think I can do that. I am also highly skeptical about those who claim they can do that consistently.

Imagine that you owned Bank of America (BAC) stock for the 20 year period ending in 2007. The company had delivered you higher dividends, high yields and very good total returns until that point. Then all of a sudden, in 2008 you hear that your favorite dividend stock has cut distributions by 50%. The company was able to cover dividends from earnings in 2007, but for several quarters in 2008 was unable to do so. If you hung on, and hoped for the best, it would have led to steep losses in dividends and capital.

On the other hand, investors who held on to General Electric (GE) after the dividend cuts, are starting to recover a bit, although they are still three-quarters of the way there in terms of dividend income. In 2009, the company cut dividends for the first time since 1938. Then it started raising the dividend in 2010, but announced it was halting further dividend growth in 2015. The truth is that at the heat of the moment, ordinary investors might not be able to objectively evaluate the situations. This includes the situation around 2008 - 2009. That is because things moved so quickly, that fundamental analysis was very difficult to perform, since fundamentals that investors receive come as a lagging indicator. When Citigroup or Bank of America cut dividends in 2008, they went on to further cut distributions and investors lost a lot of money. Fundamentals simply deteriorated very quickly. When General Electric cut distributions, I was unable at the time to see if that was the last straw before it would collapse or whether it was the last straw that would prevent further cash from leaving the ship. Either way, there was a lot of speculation that General Electric would cut dividends in late 2008 and early 2009. Jeffrey Immelt, the CEO of GE, vehemently denied that the company would cut dividends. Yet, despite those reassurances, the company did end up cutting dividends in February 2009. Today, I am seeing a similar story unfold with several high profile oil companies telling investors that the dividend will not be cut. As an investor, I am hoping they will not cut the dividend. If I am objective however, I know that in a turbulent world, anything is possible. I owe maximum prudence to myself and my family, and arrange my affairs in a way that an isolated dividend cut from one company or even one sector, will not derail my retirement plans.

Overall, I caution investors to not fall in love with a dividend paying company. This could impair the judgement of the investor, and make them stick to a position for too long or to add to a position that doesn't make sense due to deteriorating fundamentals or insane valuation.

Full Disclosure: Long GE, KO, PG, JNJ

Relevant Articles:

Emotionless Dividend Investing
Why most dividend investors never succeed
When to sell my dividend stocks?
Sector Allocations for Dividend Growth Investors
Dividends Make Investing Easier During Market Declines

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