Thursday, May 25, 2017

The Real Risk With Dividend Growth Investing

There are risks to many strategies. Some risks include permanent impairment of capital, due to an investment that ends up going to zero. Some companies would usually cut or eliminate dividends a long time prior to going under. This usually serves as a last warning sign to long-term investors like myself that something is broken in the business. But dividend cuts are not the biggest risk to dividend growth investing. This is not the risk I will discuss today.

The other risk includes mistakes of omission, where you fail to pull the trigger on a company because of fear. Then another risk is that you have identified an asset that has potential, purchased it at the right price, and it ends up meeting or exceeding your projections. However, you are not around to enjoy the full benefits of your analysis. While many cite dividend cuts as one of the biggest risks behind dividend growth investing, I believe that getting my shares acquired to be a much larger long-term risk to investment returns.

One way this could happen is if you sell a perfectly fine company. Some end up selling due to fear of the unknown. Ironically, share prices fluctuate much more than the changes in underlying fundamentals. This is why I try to focus mostly on companies that have stable earnings streams. A cyclical company with more volatile earnings streams is much tougher to value, and therefore I might be expected to receive more price volatility for each dollar of potential earnings power ( which in itself is a moving target). If you are good at timing your purchases, you may make a lot of money. If you are like almost everyone else however, chances are that exposure to cyclicals is best to be taken in a way that encourages doing nothing.

The other reason you may end up disposing of your shares is when your company gets bought out by another company. Investors usually show excitement when their shares are acquired, because the shares are acquired at a premium to the price immediately preceding the announcement.

The problem here is that a buyer will likely rob you from future improvements in the business. This means that you will have to realize all those capital gains when you sell ( assuming that you receive some cash and not stock in the new company).

In many cases, the shareholder might have been better off simply holding on to the company as a standalone business. If a smaller company is acquired by a competitor, its risk and return profile shifts dramatically.

The other issue with acquisitions occurs if you bought too high, and the buyout occurs at a price that is lower than your purchase price. This risk is one of the reasons why I try to avoid overpaying as much as I can. I do not want to overpay for a growth business, which goes through some temporary problems that reduce the P/E multiple, and is ultimately acquired at a price that is at or below my cost. To add insult to injury, I am missing out on all future growth in earnings and dividends, and now have to find another quality company for the long-term portfolio I manage. Unfortunately, the number of quality companies is limited. The availability of quality companies selling at an attractive enough entry price is even scarcer.

The whole philosophy behind dividend growth investing is that I will invest in quality companies with a track record of raising dividends annually, which I expect to further growth earnings,
dividends and intrinsic values over time. If I cannot take full advantage of the expected long-term growth in dividends and share prices, then it makes no sense to risk my capital – it might be better served elsewhere. Of course, since I never got that crystal ball from Amazon, I will keep getting bought out.

I received the idea behind this article, after reviewing the old stock manuals. Back in 1980, McCormick was almost acquired. Lucky for shareholders, it wasn't. McCormick (MKC) sold at a split-adjusted $1.16/share at the end of 1980. The stock has paid a growing amount of dividends for the subsequent 36 years. Today, that stock price is $100/share and each share rewards its rightful owner with a cool dividend of $1.88/share. This represents an astronomical yield on cost for that lucky investor who took a chance on the company at the end of 1980. If the company has been acquired instead, all that wealth would have been enjoyed by the acquirer.

I know this is an extreme example, but a $10,000 investment in McCormick (MKC) at the end of 1980, with reinvested dividends, would have turned into $1.75 million by May 2017. If the company had been acquired for double the $10,000 initial investment, shareholders would have been robbed out of over $1.7 million worth of future wealth. Using the Pareto Principle Of Dividend Investing, if you do not hold on to the few companies that do most of the heavy lifting for you, your future results may suffer greatly.

GEICO was another dividend growth company that was unfortunately acquired by Warren Buffett in 1996 for $70/share in cash. Shareholders ended up paying capital gains, which reduced the amount they had to invest. If they had received shares in Berkshire Hathaway however, they would have done much better. Buffett shrewdly paid $2.3 billion in cash for the 49% stake in GEICO which Berkshire Hathaway didn't own in 1996. This valued the whole GEICO company at roughly $4.60 billion in 1996. The company has increased insurance float to $17 billion in 2016, and has consistently earned an underwriting profit since the acquisition. Shareholders have missed out on all underwriting profits and investment income from GEICO for the past 20 years.  Buffett has been singing praises of GEICO in almost every Berkshire Hathaway annual report. This is from the 2016 Berkshire Hathaway letter to shareholders:

"GEICO’s low costs create a moat – an enduring one – that competitors are unable to cross. As a result,the company gobbles up market share year after year, ending 2016 with about 12% of industry volume. That’s up from 2.5% in 1995, the year Berkshire acquired control of GEICO."

After writing this post, I read that Brown-Forman (BF.B) had rejected a bid from Constellation Brands (STZ). I was glad that this company rejected the offer. This is because I believe Brown-Forman to be a quality dividend growth company that will likely be worth more in 10 - 20 - 30 years, and will shower its shareholders with a higher dividend during that time.

Just for the reference, I have had the following dividend cuts at the time of ownership since I started in 2008:

American Capital Strategies (ACAS) was a high yielding business development company that I purchased in 2008. I promptly sold it several months later, after the BDC suspended distributions.

State Street (STT) was another victim of the financial crisis. The company had raised dividends twice per year for 27 years in a row. Unfortunately, it cut dividends in early 2009.

General Electric (GE) was the posted child of terrible capital allocation. The company cut dividends in 2009 for the first time since 1938. Jeff Immelt had spent tens of billions of dollars repurchasing shares when prices were high, only to sell those shares at depressed prices during the financial crisis in order to obtain liquidity to save the business.

Vereit (VRE) was a Real Estate Investment trust, which ran into some trouble in 2014 and had to cut dividends.

Baxter (BAX) split into two companies (Baxter and Baxalta) a few years ago. The new companies had a combined dividend that was lower than the original one. Baxalta ultimately was acquired by Shire a few months later. So I am keeping a record for both dividend cuts and companies being acquired for a large premium.

Kinder Morgan (KMI) famously cut dividends in late 2015, in an effort to preserve liquidity. The company has not raised dividends ever since.

Enbridge Energy Management (EEQ) just recently cut dividends this year. Following the Kinder Morgan cut, I created a plan to start disposing of MLPs if I found good prices. Unfortunately, I kept a very small position of a few shares after selling off most of my stake throughout 2016. It would have cost me a large amount in commissions to dispose of the shares, which is why I kept it. As a result I have to share this as a red point, in order to be honest with myself and be honest with you the readers.

I am writing all of this because plenty of misinformed nay-sayers will tell you that dividend investing is risky, because dividends are not guaranteed. What they are missing is that in a diversified portfolio, those dividend cuts can happen. I have had dividend cuts happen. However, the dividend growth from other companies, coupled with the reinvesting of proceeds from share sales,  have actually resulted in growth in overall dividend income. While not guaranteed, dividends are more stable and reliable than capital gains. Even the father of indexing Jack Bogle understands the power of dividends and dividend growth.

I know that most naysayers will focus on the dividend cuts as a reason against dividend growth investing. My review of their arguments has determined that this is a dumb reason against dividend stocks. The dividend cuts are an inevitable part of the investing reality. Every strategy you pick, will have winners and losers. Even if you end up picking index funds (I mean asset allocation), you will still have funds that don't do well for you or even deliver long-term real losses.

The other thing naysayers are missing is that a large number of quality dividend growth companies usually get acquired. I view the companies that were acquired for cash as a failure, because I failed to realize the full potential of those investments. I have had the following companies being acquired since 2008:

Rohm and Haas (ROH) was acquired in April 2009 for $78/share in cash by Dow Chemical. It was nice to be able to sell some shares at high prices, and using the proceeds to redeploy in other quality companies at cheap valuations.

Anheuser-Busch (BUD) was acquired by Inbev in November 2008 for $70/share in cash. Again, it was nice to sell some shares at high prices and redeploy proceeds into other quality names. However, I have a feeling I would have been better off if that sale never occurred, and the company kept raising dividends and growing earnings and intrinsic values.

Family Dollar (FDO) was acquired by Dollar Tree (DLTR) a couple of years ago for a combination of cash and stock.

Chubb (CB) was acquired by ACE Ltd for cash and stock in early 2016. ACE then changed its name to Chubb. I redeployed the cash portion into some ACE shares (which turned into new Chubb).

Kraft (KRFT) was acquired by Heinz, and formed Kraft-Heinz. Shareholders received a large one-time special dividend, along with shares of Kraft-Heinz (KHC). Whenever companies I own are acquired for stock, I often keep the stock.

Kinder Morgan Management (KMR) represented a tax-efficient way to own the limited partnership units on Kinder Morgan Partners. Unfortunately, Kinder Morgan Inc decided to roll everything up in the corporate entity. The KMR shares were converted into KMI shares, which I kept. After the cut however, I disposed of most of the shares.

Baxalta (BXLT) was formed as a result of Baxter splitting into two - Baxter and Baxalta. After the split, I realized that the combined companies are cutting dividends, so I started disposing of my shares. Fortunately, I kept some shares of each. Baxalta ended up getting acquired by Shire for a combination of cash and stock.

In my personal experience,  I have had companies that were targeted by acquirers, which were thankfully rejected by the boards. One example includes Clorox (CLX), which was pursued by Carl Icahn in July 2011 for $76.50/cash. Currently, the stock is selling for over $131/share and has paid over $17/share in dividends to its shareholders. The stock has generated a total return of 133% since July 1, 2011 for its shareholders ( this amount includes reinvested dividends)

Another recent example includes Anglo-Dutch consumer products conglomerate Unilever (UL), which rejected the takeover from Kraft-Heinz a few months ago.


Plenty of investors are irrationally afraid of dividend growth investing, because they have been scared of potential dividend cuts. My analysis of my investments over the past decade has shown that acquisitions of quality dividend payers is almost as likely as dividend cuts. I personally view acquisitions are worse off than dividend cuts. Acquisitions do wonders for a portfolio in the short term. The downside is that you fail to take full advantage of the success story that would have showered you with dividends for decades to come otherwise. If you get cash for your stock, you also have to recognize capital gains for your taxable portfolio. In addition, you have to find good quality companies to replace the income stream being acquired. Even if your shares are exchanged for shares in the acquirer, the risk/return profile of the new investment could be starkly different. This could create an instance that may require you to perform further monitoring in order to determine if the new company is suitable for your portfolio.

Relevant Articles:

Dividend Growth Stocks Are Still Great Acquisition Targets
Dividend Stocks make great acquisitions
Should you celebrate when your dividend paying company is about to be acquired?
Why would I not sell dividend stocks even after a 1000% gain?
Mistakes of Omission Can Be Costlier than Mistakes of Commission

Popular Posts