Wednesday, March 25, 2020

Dividend Investing and Covid-19 Disruptions

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

― Benjamin Graham

The price of securities fluctuates more widely than the change in underlying fundamental values, such as dividends and earnings. I generally ignore price fluctuations, unless I can take advantage of any bargains.

Based on some limited sample conversations and interactions I have had, I wanted to share my viewpoint today. I think that this virus is dangerous, and the economy is experiencing something it hasn't experienced before. But I still believe that stock prices move more than the underlying intrinsic values of a business. Buffett defines intrinsic value as the sum of total cashflows you will receive from a business from now until the end of time. For the purposes of this exercise today, I am looking at dividends, which are cash flows in your pocket. And I use Johnson & Johnson as an example to walk you through my reasoning as to why I believe the stock price declines are higher than any potential decreases in intrinsic value for dividend stocks in general. While some will not survive, a lot will, and their profits should more than compensate for the losers in a diversified dividend portfolio. This has always been the case.

I also try to make the case that a disciplined investor should do well, as long as they keep to their plan of regular investment every month, building diversified portfolios, keeping costs low, reinvesting dividends and staying the course. This plan worked even during the Great Depression. This is the model I use in my investing newsletter, in order to reach dividend investing goals.

Let's start this by reviewing Johnson & Johnson, a dividend king with a 57 year history of annual dividend increases. Johnson & Johnson (JNJ) paid $3.54/share in 2018, $3.75/share in 2019 and is on track to pay $3.80/share in 2020. The price of Johnson & Johnson has fluctuated widely at 42.10 to 33.50 times dividends in 2018. The range was 39.40 to 33.33 times dividends in 2019. So far in 2020 the price has fluctuated between 40.66 and 28.72 times dividends.

And if you think that there is some logic to these ranges, Johnson & Johnson sold between 38 and 24.90 times dividends in 2017, and paid $3.32/share.

The prices move a lot more than changes in fundamentals, because stock market participants are a fickle crowd. Their perceptions change based on fear and greed, expectations on the economy, alternative investments, the treasury yields etc. And that is a generally wide fluctuation on true stock values for a company like Johnson & Johnson which is generally considered to be defensive and somewhat predictable.

Price to Dividends
Price to Dividends

Dividend Per Share
 $  3.80
 $   3.75
 $   3.54
 $   3.32
High for the Year
Low for the Year

Imagine what happens when there is extra uncertainty added to the perceptions of Mr Market on the stability of earnings and dividends. The ranges get out of control in the short-run.

Enter the situation over the past month, where the spread of Covid-19 outside China is causing widespread disruptions in the world economy. It seems like we are only getting started too, which gives everyone a ton of anxiety.

With the shutdown of a large part of the US economy, people in quarantine, and cities shutting down, we are seeing some visible economic disruptions. We will see high unemployment, and a lot of businesses going under, as the economic activity grinds to a halt. No one knows how long this would last for. It is a scary time. It feels as scary as the 2007 – 2009 financial crisis, The Great Depression, World War I and II combined with the Spanish Flu of 1918.

I do believe that financial information we see such as numbers on earnings, GDP, will look very volatile for at least Q1 and Q2 of 2020. I am hopeful that by Q3 and Q4 we will see a rebound from the disruption. A lot of businesses and consumers may not make it through this crisis, which is why the US government is stepping up its efforts to take a bigger role in the economy through a variety of methods within its toolkit. That would soften the blow, but we are still in for a rough ride.

The companies that survive this epidemic will see their fortunes rebound. They will continue delivering higher earnings and dividends to their long-term shareholders who stick with them through thick or thin.

The most important thing is for your company investments to survive, even if it means a few messy quarters that look absolutely horrifying.

Now is the time I need to remind you that you are investing in equities not for the next quarter or two, but for the next 20 or 30 years. As such, based on historical activity, you would have learned that recessions do happen at least once or twice per decade. In addition, stocks tend to drop by a lot a few times per decade, and crash several times per century. The most frustrating part is that each crisis looks different than the past. In addition, while stocks have delivered annualized total returns of 10%/year since 1926, their year to year returns have been very volatile and all over the place.

The value of the stock is the amount of future dividends you will receive from now until the end of time.

If you will hold a stock for 30 years, and it will pay a dividend of $2/year, it should be worth roughly $60/share. If the operations are disrupted in year one, and it earns zero but the business is intact and future business prospects are intact, the amount of dividends will be $58. If there is a catch-up to $2.07/share for 29 years, the value of the business should be unchanged. This is a concept called dividend payback, which I last discussed a decade ago.

You can argue with me that I should use a discount interest rate of 5% or 10%, to discount those future values to the present. I would argue back that interest rates will likely remain low for quite some time. I would also argue back that my analysis doesn’t assume any growth. So if earnings per share and dividends per share grow by 5%/year for 30 years, and I discount at 5%, then I am back to $2/share.

Obviously this is a rudimentary model for evaluating long-term value of dividends received by companies. The other thing to consider is that with dividend stocks, on average, I would expect to receive my original purchase price back in the form of dividends within 15 – 25 years from the time of investment. I would also expect that a diversified portfolio of these businesses will have a value at that time as well. For example, if you look at the S&P 500 and its dividend history, you can see that investors have managed to get their money back in the form of dividends within 15 – 25 years, and still own a diversified portfolio of growing companies as well.

If I look at a company like Johnson & Johnson (JNJ), I see it selling for $120/share today. I see annual dividends of $3.80/share. If the dividend is kept unchanged, our investor would recoup their investment in Johnson & Johnson using dividends alone in 31.50 years. That is a very long dividend payback.

If history taught anything, it is that companies like Johnson & Johnson regularly grow dividends. It has increased dividends for 57 years in a row, through a lot of challenging environments, making it one of the few dividend kings out there.

Let's look at two scenarios of how things can unfold. I just wanted to illustrate that an year or two of something bad happening should not mean the end of the world for a company that has the ability to survive the storm. A resilient company like Johnson & Johnson fits the bill as do a large portion of the companies on the dividend aristocrats list. While the value will be affected, it shouldn't be affected by as much as to justify a 35% decline in US stocks in one month.

Under Scenario A, everything works out, with no major issues to the dividend. If we assume annual dividend payment of $3.80/share in 2020, and annualized dividend growth of 4%/year, we could expect that annual dividends will reach $8.32/share in 2040. This is a slower than average annualized growth in dividends, which I wanted to model from a conservative base scenario. Obviously, the upside will take care of itself if growth is higher, but it is good to have low expectations in investing in order to ensure your happiness.

Anyway, if you collect all dividend payments from 2020 to 2040, you end up with $121.48/share in dividend payments. If the stock yields 4% at the time, it may also sell for a price of $208/share. If we reinvested those dividends when yields were 3% of course, we would have a net worth of roughly $390 in 2040, which is not too bad.

Under Scenario B, there is disruption, causing JNJ to stop paying dividends in 2020 and 2021. If Johnson & Johnson doesn’t pay $3.80 in annual dividend income in 2020 due to the Covid-19 epidemic causing shutdowns, everyone will panic, because the company has never eliminated dividends in its 76-year history as a public company. But, if the company survives this crisis, and resumed paying dividends in 2022, the total value of our expected dividends and share price would be impacted by this crisis today.

It would take until 2042 to recover the initial purchasing price through dividends alone, or two years longer. The value of the investment, assuming reinvesting dividends when the shares yield 3% will be $340 in 2040 and not hit $390 until 2042. So the value for 2040 is impaired by 12% - 13% from the dividend elimination for 2 years. As an investor, this means you would have to wait longer, and remain patient.

I illustrate both scenarios with the table below.

I am not stating that Johnson & Johnson will cut or eliminate dividends in 2020 and 2021. There are however a lot of great companies that are in a difficult financial position from this virus, and that position is not their fault. Noone would have expected that this virus would stop people from going out to eat in restaurants like McDonald's for example. They can easily adapt their business model to a point where they provide deliveries and order pick-ups and more drive-through ordering, but there would still be an impact to the business. Therefore, this recession will be different from others, so we may be seeing problems in otherwise stable companies. In another example, Sysco will probably face some near-term turbulence, and it may lose a portion of its clients. However, it has a strong position, and will likely survive and thrive in the rebound, even if it hurts in 2020.

The key risk is whether a company will survive this economic shutdown, without going bankrupt. A company that can survive this crisis, should protect the equity interests of its shareholders and let them participate on the rebound in economic activity after we beat the virus, and over the next few decades worth of growth as well. If the company goes bankrupts, and shareholders are wiped out, it may be owned by its former creditors, and they will benefit from its economic gains after recapitalizing the enterprise. That’s why we need to focus on survivability first.

The other risk is at the personal investor level. If unemployment is high, our investor may find themselves without a job. Some individuals have an emergency fund covering 3 – 6 months, on top of any termination benefits and state unemployment compensation. This could be a troubling time to be in, if you are out of a job, and out of other options. If you cannot find another job, but have bills to pay and no source of income, you will be forced to dip into savings.

Of course, you may have options to earn income elsewhere or cut expenses to the bone, to get you through these challenging conditions. You can always think outside the box, and pivot into something else, until the storm passes through.

I did want to discuss what I view as worst case scenarios, and how they would impact dividend portfolios. In my modeling, I project Great Depression type environments, with 25% unemployment, massive dividend cuts etc. This establishes a worst case base scenario, which lets me see that things are not as scary as they are from a financial perspective. We will rebound from this mess. I just hope we are all healthy and manage to avoid getting sick. That’s the most important thing – if we are healthy, we can always make sure that we take care of the power of compounding and continue building our dividend incomes over time.

My analysis of investing during the Great Depression showed me that the investor who patiently invested in blue chip stocks on a regular basis did come out ahead after a couple of decades of investing. You can read the article here: Everybody Ought to Be Rich

In the meantime, I believe that continuing with an investment plan is still a wise choice today. I am investing every month in a few dividends growth stocks I view as attractively valued. I share that information with readers of my dividend growth investor newsletter. I am also investing automatically in my 401 (k) plan at work. I am maxing it out, so unfortunately I cannot increase contributions at this moment.

The prices may fluctuate and go down further from here, but I know I am owning stock in some of the world's best companies.  If history is any guide, buying equity ownership in US companies has always worked in the past, and they have always recovered. It may take time, but as an investor with a 20 - 40 year time horizon, I can afford to wait this out.

This too shall pass.

The investors who will reach their dividend crossover point in 2030 will be the ones that kept investing during 2020's bear market.

Relevant Articles:

- How to define risk in dividend paying stocks?
Risk Management
Dividend Aristocrats List for 2020
Dividend Investors Should Ignore Market Fluctuations

Popular Posts