In Part 1 I
looked at a dividend
investor who buys a large cap dividend stock
after the announcement of the dividend cut is made. In Part
2 I will look at the buy and hold investor who has created a
dividend stock portfolio and has been in
the stock for 10 years and rather than being
dismayed at the dividend cut looks at it as a long term
opportunity. Is such a dividend investor correct? Let's use our
theoretical study once again and this time try to determine
the best of course of action for a long term dividend investor who
has had his dividend stock portfolio damaged by the dividend cut.
When a stock
stock makes a cut, it almost always means the company is in
trouble. Theoretically speaking many long term investors
would consider the best course of action is to leave
the stock. But what about a big behemoth of a stock such as
General Electric, Wells Fargo stock, Citicorp stock? All of these
companies (and many more) cut their dividends dramatically
in the bear market collapse in late 2008 to early 2009.
Let's go back to our General Electric stock and try to
determine what a long term dividend investor might consider doing.
Stocks like General Electric have been on the stock market
for decades. These are giants in their own industry with
literally tens of billions in sales. Therefore one thing a
dividend
investor knows is that unlike stocks such as WorldCom or
Enron, stock like GE have been in existence for a very
long time and should, in all likelihood continue to stay in
existence.
With that being the case, a long term dividend investor
might look at a
decline in stock value as an opportunity to add to their
dividend stock portfolio. However when a
dividend paying stock cuts its dividend, the loss is two
fold - capital depreciation leading to substantial
investment losses especially if the investor should sell at
a time of loss, and the loss of income through the dividend
cut.
Let's go back 10 years and view a number of different
strategies a buy and hold investor or dividend investor
could consider.
No commissions are taken into
account for any of the trades shown here.
STUDY 1: THE LONG TERM HORIZON DIVIDEND STOCK
BUYER
Many long term dividend investors are just seeking the
highest paying dividend stock or highest yield dividend
stock. Many such investors set up a basic plan to average
themselves into the stock over a period of many years. They
do not have a complex dividend investment strategy. This
is the same simple strategy that many mutual fund investors or ETF
investors take. Other investors use a dollar cost averaging
in strategy. There is not a lot of dividend investment strategizing here,
just a simple buy, collect the stock dividend and buy again. This
will be our first study.
If an investor had bought 100 shares of GE stock at the close
on the first trading day of January of each year here is
what the investment in General Electric would look like as
of May 27 2011, (the time of writing this article):
JAN 2 2001 - $43.75 = $4375.00 - Dividends Earned To
Date - $852.00
JAN 2 2002 - $40.95 = $4095.00 - Dividends Earned To
Date - $786.00
JAN 2 2003 - $25.48 = $2548.00 - Dividends Earned To
Date - $713.00
JAN 2 2004 - $31.12 = $3112.00 - Dividends Earned To
Date - $636.00
JAN 3 2005 - $36.59 = $3659.00 - Dividends Earned To
Date - $554.00
JAN 2 2006 - $35.37 = $3537.00 - Dividends Earned To
Date - $463.00
JAN 3 2007 - $37.97 = $3797.00 - Dividends Earned To
Date - $360.00
JAN 2 2008 - $36.76 = $3676.00 - Dividends Earned To
Date - $276.00
JAN 2 2009 - $17.07 = $1707.00 - Dividends Earned To
Date - $121.00
JAN 2 2010 - $15.13 = $1513.00 - Dividends Earned To
Date - $62.00
JAN 3 2011 - $18.28 = $1828.00 - Dividends Earned To
Date - $14.00
TOTALS: 1100 shares
TOTAL CAPITAL INVESTED: $33757.00 / 1100 shares =
average share price - $30.69
Dividend Income Earned since Jan 2 2001: $4837.00
STOCK
COST BASIS: $33757.00 invested less $4837.00 in dividends =
$28920.00 / 1100 shares = $26.29 per share
After being in GE stock for 11 years, if sold today (May 27
2011) the loss on the total investment would be $19.47 X
1100 shares = $21,417.00 minus the dividends earned for a
cost basis of $28920.00 which results in a loss of $7503.00
or 25%.
After 11 years of
being in the stock the dividend investor has lost 25% of their capital AFTER
dividends are taken into account.
If you set aside dividend
payments it is even worse, with a total capital loss of
$12,340.00 or 36%.
This would spell disaster for many dividend stock
portfolios.
STUDY 2: BUYING MORE SHARES AFTER THE
DIVIDEND CUT
Taking the above figures and totals, what would happen if
the long term investor decided to purchase shares the day
after the dividend cut was
announced. Looking at the chart below, GE stock closed
during the stock market panic on March 2
2009 at $7.60. The next few strategies are based on a
dividend investor adding more stock to his dividend stock
portfolio the day after the dividend cut.
Here are some
samples of what might have happened:
A) Buy 100 shares at $7.60
This would mean a capital investment of $760, which when
added to the original amount invested of $33757.00 equals
$34517.00 which divided by 1200 shares equals a cost basis
of $28.76 before dividends.
B) Invest 25% of the original investment into GE stock
Original invested amount equals $33757.00 which for 25%
would add an additional investment of $8,439.25. This
would mean the dividend investor would purchase 1100 shares
of General Electric Stock at $7.60 for a total outlay of
$8360.00.
The investor would now have $42193.00
invested in General Electric stock. The cost basis on the
stock would be $42,193.00 / 2210 shares = $19.17 before
dividends are taken into account. This though would require
a considerable increase in their dividend stock portfolio.
It also means they have invested over $8,000 in a dividend
stock that is paying a very small dividend. At 10 cents on
$7.60, the return is 1.31% annual. This is certainly not the
highest paying dividend stock.
There are lots of variants an investor could consider
including using 10% or 15% of the original investment as the
amount they would be willing to risk in General Electric
Stock. As
you can see though, by selecting 25% an investor has reduced
his cost basis considerably in the stock. This means that
the dividends earned to date and all future dividends are
not being considered to reduce the overall cost basis in the
stock. However if an investor had $100,000.00 already
invested in GE stock, they may not be pleased to have to invest
another $25,000.00. Consider an investor who may have
$250,000 invested in GE stock. Would they wish to risk
another $62,500.00 at the height of a stock market panic or
market meltdown?
C) Buy More Shares Looking For A Quick
Capital Gain
This brings up the possibility of strategy C. The
investor takes 25%, buys GE stock at the close of business
on the day after the announcement of the dividend cut, but
with the full knowledge that they intend to sell that stock
for a profit should GE stock recover. This then means the
investor is risking his capital, but upon a recovery, the
investor will sell that stock and the
capital will be returned with a profit and the initial
investment in GE Stock prior to the dividend cut will remain intact. This would perhaps have the
least long term impact on a dividend stock portfolio, but
there is still risk.
I will not show figures for
this strategy as the selling point would have to be
determined by the investor. After purchasing shares for
$7.60, they might sell those shares at $10.00, $12.00 or
even $14.00. Each price difference would affect the amount
of profit and the cost basis of the original investment.
SUMMARY
While these strategies could work for a number of dividend
stocks, would this type of strategy work for every large cap
dividend stock that has a dividend cut? No, because there is
never a guarantee that a stock that has collapsed will in
fact recover and reinstate its dividend. Citicorp stock, AIG
stock and others can destroy a dividend stock
portfolio.
The problem with investing just for dividends is, there is no
guarantee the dividend stock will continue to make payments
and increase those payments. When a dividend investor risks
capital for 3%, 4%, 5% or even 7% annual dividend payments, the
collapse of a single dividend stock and a dividend cut, can
damage a dividend stock portfolio. That damage can take
years if not decades to recover.
So are dividend stocks that have a dividend cut, good buys?
I believe they are, but only for investors who are stock traders.
Long term dividend investors I think, need to consider a
number of different strategies, which is the focus of Part
3.
