Wednesday, December 14, 2016

What is dividend investment risk?

To many investors and financial professionals, the term investment risk is widely discussed. This term usually entails situations where the value of the investment fluctuates in quoted value. The saying goes that if you purchased Johnson & Johnson (JNJ) at $70/share in 2008, and the stock goes down to $45/share, your risk has increased.

I define dividend investment risk as a situation where my investment capital is permanently impaired. If I buy a stock which essentially goes to zero, I would have essentially damaged my capital, as I would be unable to generate much in income from that portion of my portfolio. I would be unable to compound my capital from that point, because anything times zero is still zero.

The scenario with Johnson & Johnson stock mentioned in the first paragraph really happened during the 2008 – 2009 bear market. However, the fundamentals of Johnson & Johnson did not deteriorate, and it was still the great business it always was. In fact, earnings didn’t get depressed as much as other industries like Financial Institutions, and dividends kept getting raised and paid like clockwork. Earnings per share increased from $3.73 in 2006 to $4.40 by 2009, while dividends per share went from $1.46 in 2006 to $1.93 by 2009. The company is expected to earn $6.71/share in 2016, and pays a per share dividend of $3.20/year. Incidentally, I find the company to be attractively valued today. Check my analysis of Johnson & Johnson for more information about the company.

Thus, the risk of a permanent loss of capital from an investment in Johnson & Johnson at the time of the crisis was very low. As a result, what the traditional view might have seen as risky at the depths of the recession in 2008 – 2009, the smart dividend investor would have seen an opportunity.

Many financial institutions in the US had problems that led to dividend cuts in the early 1990s and in 2007 – 2009. You might be surprised to hear that Citicorp (C) was a member of the dividend champions index all the way until 1991. The company had raised distributions for 33 consecutive years in a row. Unfortunately, the company cut dividends in 1991, ending the streak.

In 1998, Citicorp merged with Travellers Group to form Citigroup.

Almost 17 years later, Citigroup cut dividends once again. The reason why you cannot see that if you look at Citigroups dividend history today, is because the current entity was formed in 1998, when Travelers and Citicorp merged. As a result Travelers Group purchasing the entirety of Citicorp shares for $70 billion, and issuing 2.5 new Citigroup shares for each Citicorp share. Investors in Citigroup from 2007 suffered a substantial decline in share prices and dividend incomes.

This is where it is important to develop the habit of trying to understand the company you are investing in, and trying to understand its industry, how defensible income is during recessions etc. Reviewing simply the history of dividend increases is not sufficient. You also need to understand the business, and determine if it can continue earning money and paying that dividend throughout the cycle. If the company cuts dividends at the low point of the cycle, you are out a large chunk of your capital and a large chunk of your income. It pays to research your companies, in order to determine the defensibility of their income streams. It is also more difficult to evaluate cyclical companies at the bottom of the cycle, because it is more difficult to determine if the company's earnings will bounce back, and whether it can continue as a going concern. When earnings and dividends do bounce back after a recession, they show astounding gains. They lure in the investors, who have not studied history, and are not aware of the cyclical nature of things. Of course, investors should not easily project the current state of affairs in any enterprise on to infinity, without requiring some adequate margin of safety for their capital and income.

It is easy to say in hindsight that investors should have bought Johnson & Johnson, and not bought Citigroup. It is possible that both seemed like a no brainer to a new dividend investor in late 2007. One of the companies sufferred almost immediately, while the other prospered. On the other hand, students of financial history would have known that financials are subject to cyclical fluctuations in fundamental performance, driven by the economic cycle. Either way, predicting the future is difficult, even when we use quality dividend champions as a starting point. Perhaps the dividend cut in early 2008 from Citigroup should have been a warning sign to get out fast.

In order to reduce the risk of a permanent portfolio value and dividend impairment, the investor should diversify their risk by focusing on companies from different industries, that is built slowly over time.

A smart dividend investor would not have held just one company in their portfolio. Spreading risk against the permanent damage that a few bad apples can cause is paramount for avoidance of permanent destruction of capital. Few people can know with certainty whether Citigroup (C) or Johnson & Johnson will do well over the next decade or two. This is why we diversify, in order to reduce risk of permanent impairment of capital, that would derail our retirements.

I construct diversified portfolios not to outperform S&P 500, or to achieve a certain level of beta, but to protect my capital and income in case an industry or two has hiccups that lead to losses. It is easier to sleep well enough when you have built a diversified stream of income, which is passive in nature, and does not depend on you showing up to a place of business for 40 hours/week, 52 weeks per year. I construct my dividend portfolios, so that they throw off enough money to pay for my living expenses in retirement/financial independence. As long as my goals are achieved, I could not care less about performance relative to S&P 500, EAFE, Emerging Market Stocks, etc.

Full Disclosure: Long JNJ

Relevant Articles:

Dividend Investing During the Financial Crisis
Investors Get Paid for Holding Dividend Stocks
How to define risk in dividend paying stocks?
Six lessons I learned from the financial crisis
Stress Testing Your Dividend Portfolio

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