Make Sure You Can ‘Eat’ Your Dividends

09/21/2011 7:30 am EST

Focus: MARKETS

Josh Peters

Editor, Morningstar DividendInvestor

In this crazy market, income investors need to make sure they stick with good, solid dividend payers and don’t get wrapped up in the frenzy says Josh Peters of Morningstar DividendInvestor.

The ghosts of 2008 are back! Their chains rattling, their every moan reported breathlessly by the financial media, the world is about to end—again!

In the 11 trading days through August 8, the S&P 500 Index shed nearly 17% of its value. It was, to quote a recent issue of Barron’s, “either a slow-motion crash or an incredibly rapid correction.”

Amid the carnage, I found myself thinking about sardines, of all things. Not because I like sardines or, for that matter, any other fish that typically comes in a can.

Instead, sardines popped into my head because of a little homily told by Seth Klarman, the highly accomplished (and admirably media-shy) value investor, in his 1991 book, Margin of Safety. I think it’s worth quoting in full:

There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”

As stock prices plunged, it occurred to me that we were suddenly obliged to eat our sardines. Certainly many of us investors hadn’t planned to eat our trading sardines. Others, who perhaps weren’t intending to be mere traders or speculators, still hadn’t thought too carefully about the merchandise when buying.

I haven’t lost much sleep in this decline to date. I’m fully prepared to eat my sardines, because that’s what I bought them for—and how I chose which ones to buy. Uniquely in the stock market, high-quality, high-payout stocks are meant for eating, not trading.

What a wonderful thing that is for times like these!

Being Prepared
The first preparatory step for unpleasant circumstances is to know thyself. Failure to plan, as they say, is a plan to fail. What you’re trying to accomplish with your portfolio makes all the difference in the world.

“To make money” is an honest answer, but an unenlightening one; the market is not always going to go up. Some mean to beat some index of broad market performance, though it’s certainly possible to beat the market and still suffer a loss of value.

This is why I try to make my strategy as clear as I possibly can. Our objective is to build a large stream of income through cash dividends that will be resilient during downturns and should grow at least as fast as inflation—and preferably much faster—over long time horizons.

While rising dividends should and do correlate with eventual price appreciation, these correlations are not nearly tight enough to count on capital gains coming in a specific period of time, so we don’t rely on capital gains to meet our day-to-day or year-to-year goals.

For those of us in need of regular cash payments from our portfolios, large, reliable, and growing dividends are the best way to get them. For those of us who don’t need cash right now, falling stock prices and rising yields makes dividend reinvestment much more profitable.

Of course, the strategy is only the start. Execution—specifically in terms of security selection—makes all the difference in the world. The time to be defensive is when you’re evaluating stocks and making purchases; if conditions go bad later on, it will often be too late to prevent a costly loss.

That’s why every evaluation of a stock should start with dividend safety, with the next recession squarely in view. There are plenty of ways to lose money in stocks, but taking a dividend cut is one of the surest and, especially for our investment purposes, one of the most painful.

I write, regrettably, from experience: Going into the last crash, I held a number of stocks in the Builder and Harvest portfolios, whose dividends cracked under stress.

You might say I followed the money right into the ditch—financials were easily the largest and most generous source of dividend income in 2007, and the sector hadn’t endured any meaningful spell of dividend cutting in over 15 years.

The good news was that most of our dividends weren’t cut. The impact of the hits we took was actually smaller than those experienced by most high-yield indexes, and the subsequent rebound has been rewarding (particularly for the high-yield Harvest).

Where We’re Headed
Even now, older and (hopefully) wiser, I know that I’m not going to get the dividend safety question right in every single instance—but it remains the first and best line of defense.

In terms of where the stock market goes from here, it will be interesting to see what happens—which is another way of saying I really have no idea.

In recent months, I’ve written about a persistent lack of buying opportunities for new money. High prices generally mean low yields, subpar total return potential, and above-average vulnerability to loss.

That situation may be starting to resolve itself: With falling prices I now see somewhat higher yields, better total return prospects, and even a bit less risk than there was at the market’s peak in April.

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