Wednesday, March 2, 2016

What dividend cuts? What market correction?

The beginning of this year was characterized with a correction in stock markets around the world. The big problem has been the energy sector, which has dragged down returns for investors. Some like myself have experienced dividend cuts in the likes of Kinder Morgan (KMI) and ConocoPhillips (COP). Others, have experienced dividend cuts in the likes of BHP Billiton (BBL). It is obvious that the energy sector is having a tough time, which by default translates into companies that do business in the energy field, their suppliers, their bankers and certain economies will experience turbulence as a result of this downturn.

As a somewhat visible private investor, I receive a lot of hate mail where the sender of the message secretly gloats at what they perceive to be my current misfortune. Unfortunately, their gloating cannot be further away from the truth. The sender ignores the following important facts when sending me hate mail:

1) When a company I own cuts dividends, I can immediately reinvest that money in another income producing opportunity.

2) If I sold at a loss in a taxable account, I receive a tax benefit that flows to my personal 1040 that could amount to anywhere from 15% - 25% of the loss.

3) Since I hold a diversified portfolio of dividend growth stocks, I will get dividend hikes that will offset the amount of the loss in income within a year or so at a conservative rates of 6% annual dividend growth. If I hold 50 companies on an equal weight basis, the complete loss of income in three of those companies can be offset by an average growth of approximately 6.40% by the other 47 components.

4) If I reinvest dividends, my dividend income will also be expected to increase at the rate of dividend yield

5) In points 1 – 4 above I am only discussing how existing investments have helped my dividend income bounce back after a dividend cut. This will likely be the case in 2016 as well. But please do not forget that I am also putting in fresh capital to work every two weeks – this increases the amount of future dividend income I can expect to collect.

- A large portion of that money provides me with a tax-break upfront ( and thus more money to compound for me than merely using taxable accounts),

- It also provides me with the ability to compound money without paying taxes for the next 30 – 40 years ( a portion of it will never incur taxes under current legislation)

- Since the largest portion of my tax-deferred money is in my 401 (k) and H S A accounts, I am limited to low cost index funds there. These funds have average yields of approximately 2%. If I were to sell those funds, and reinvest those proceeds in individual dividend growth stocks, I can immediately boost my dividend income from this source by at least 50%. Therefore, my expected dividend income is lower than what it could be under normal circumstances.

While the decline in stock prices in some sectors and the amount of dividend cuts has been unfortunate, there are a lot of other sectors that have kept doing well. For example, consumer staples, utilities, telecommunications have been pretty nice spots to be in. In fact, other than the energy sector, my portfolio looks in pretty good shape. I cannot forecast which sector will do badly next, but I can forecast that a diversified collection of quality businesses with a track record of growing earnings and boosting dividends will do well over time.

So at this stage, despite the losses in energy dividends, the rest of the portfolio continues to chug along pretty nicely. Dividend investing has its best moments when things are turbulent in the markets. I have had several companies I own hit all-time-highs, while everyone around me is suffering. Perhaps this is a temporary situation, and we will see losses across the board pretty soon within the next year or so?

During the 2007 – 2009 bear market, stable recession proof companies held up their own initially, while financials cratered, until they were indiscriminately sold off. During the 2000 – 2003 bear market, we saw a similar picture where old-economy stocks did very well initially while tech stocks cratered, until they were indiscriminately sold at the latter parts of the downturn. Perhaps, if this correction continues, we may be able to see quality companies available at attractive valuations.

For example, I am interested in increasing my exposure to quality companies like Hershey (HSY), McCormick (MKC), Brown-Forman (BF.B), Dr Pepper Snapple (DPS), General Mills (GIS), McGraw Hill (MHFI), Moody’s (MCO), Visa (V) etc. Those companies are either selling at the top range of what I am willing to pay for them, or are overvalued. As a result, I have not gotten excited much yet. I am aware that there are other bargains out there, but I have those companies on my wish list for more shares. Let's see if we can get those shares at 15 - 16 times earnings within one year.

Full Disclosure: Long HSY, MKC, BF.B, DPS, GIS, MHFI, V, KMI, COP,

Relevant Articles:

Five World Class Dividend Stocks to Buy During the next dip
Buying Quality Companies at a Reasonable Price is Very Important
Dividend Portfolios – concentrate or diversify?
Sector Allocations for Dividend Growth Investors
Market Declines: An Opportunity to Acquire Quality Dividend Stocks

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