Warren Buffett once wrote, “Our favorite holding period is forever.” While it's hard to argue with the Oracle of Omaha, most of us will find that “forever” doesn’t work in all cases. When stocks head south, second guessing increases.
Are your clients wondering why you suggested a good dividend payer that has sunk with the recent market downturn? If so, it's time for a check on why you recommended the stock and whether that reason is still valid. If the stock has been a solid dividend growth equity, has the company continued to increase its shareholder payments? Has the stock fallen in line with the overall market? If the answer to those two questions is yes, there’s a good chance that the position is worth holding.
If the stock has declined more than the overall market, maybe it’s time to sell. But it's not a certainty. Here are some factors to consider:
- Was the decline due to a one-time event that can be overcome? For example, did a natural disaster, shortage of raw materials, or a labor strike disrupt the company’s operations?
- Has the company radically changed its business model? Did the world’s largest manufacturer of widgets just announce plans to operate amusement parks—a field it knows nothing about?
- Can the company afford its dividend payment? The key here is to look at free cash flow, or cash from operations less capital expenditures. Various forms of earnings are a much poorer guide to dividend affordability because management can massage them to show almost anything. There is no standard definition of “adjusted operating earnings.” As a value manager once noted, this metric amounts to “earnings minus the bad stuff.”
When you look at a company’s free cash flow, take a close look. IBM, for example, has seen declining total cash flow for the past three years. Yet, the company has continued to raise its dividend and has a robust share repurchase program. In fact, the total IBM spends on dividends and buybacks (mostly the latter) exceeds the company’s free cash flow. How is that possible? In a word: debt. IBM has been borrowing to help fund its dividend and share repurchase operations. Even for a company of this size, that can’t go on forever.
A more difficult situation is a long-term dividend increaser that stops raising its dividend, or even cuts it. During the financial crisis, many companies found themselves in this situation. Often, these stocks decline sharply even before the cut is announced as worried holders dump shares.
Here are some things to consider:
- If the stock has declined, will selling result in a capital loss, or simply a reduced gain? Can a loss, if that’s the result, be used to offset a capital gain?
- Will you be able to replace the stock with an investment that provides a comparable yield at a comparable risk? This is harder than it looks. If the stock has been held for a number of years, the current yield is probably lower than the current dividend expressed as a percentage of the cost—the “yield on cost.”
Sometimes it pays to just hang on. General Electric slashed its quarterly dividend from 31 cents to 10 cents during the financial crisis. Now in the process of returning to its industrial roots, GE has sold off most of its financial services operations and has raised its dividend regularly since 2010. GE now pays 23 cents per quarter and is likely to surpass its old dividend high within a couple of years.
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