While this article likely won’t make me many new friends (rather to the contrary), I find it necessary to discuss this topic as it’s often presented as an almost infallible recipe for success. The dividend investing strategy sounds great and if done properly has a psychological advantage. But my observation shows unfortunately a drift towards low-quality stocks and lots of sugarcoating which needs to be addressed.

Summary and key takeaways from today’s Weekly
– The quality of dividend picks has declined.
– Important factors are being ignored and the risk of permanent loss of capital increases dramatically when being blinded only by the history.
– What worked in the last 40 years in an environment of falling interest rates and other favorable tailwinds, will likely be challenged now. 

Betting on dividends as the preferred investment strategy when finally set up promises not only to be less time-consuming than frequent and active portfolio management, but also to run almost on autopilot.

The dividend investor is promised not to have to worry anymore about market and stock fluctuations, because the focus is laid on the income stream from dividends. By buying stocks of companies with seemingly proven histories and long streaks of uninterrupted dividend payments, the formula for success is found.

But it gets even better.

Together with adding frequently money from the salary, this is an almost given success to become rich without doing anything. The snowball is fed and growing.

It only takes time.

At least that’s how it is advertised by the crowd.

You’d likely heard out the irony in my voice, respectively fingers.

As this strategy has become not only a small trend, but almost a sectarian religion where criticism is not welcome, I see the need to again point at some things worth considering instead of following blindly.

My strategy is not tilted towards dividend stocks, even though there a a few dividend payers among my best stock ideas for my members.

I also do not want to make this concept sound bad at all.

But a serious investor is open for criticism and learning from mistakes.

It is my observation that especially younger and inexperienced people have simplified it to such a degree that carelessness has become their biggest enemy. While I do not apply this strategy myself, I acknowledge that there are positives to it like the psychological effect of not having to worry about price fluctuations. That’s great for nervous people.

In case they own the right stocks or stay away from the bad ones. As a risk focussed investor, however, one should care about the negatives with the same amount of attention.

That’s what I am going to discuss today.

The average total return of my best stock ideas is +12.2%, slightly trailing the S&P500 and the iShares MSCI World ETF.

^{as per 28 February 2024 market close – since August 2022}

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Good idea – questionable execution

I thought quite a bit longer than usually about how to start this weekly.

As Warren Buffett who is admired by many investors, also from the dividend crowd, even though he is not a dividend investor per se, his latest letter to shareholders from last weekend came in handy for me.

There, Buffett being a realist and certainly not a market timer or crash prophet, warned about a few things that should be taken seriously. You can find the letter here.

On page 7 there’s a great section everyone should have read and understood.

Buffett discusses in brief casino-like behavior, human emotions towards stocks and avoiding serious mistakes which lead to the permanent loss of capital.

What’s the hook?

My observation in recent years is that the “dividend strategy” leads many (not all) to risk permanent loss of capital that Buffett mentioned by investing very carelessly in stocks of companies that have at least one of these negative characteristics:

• the business is already past its peak
• weak balance sheets
• interest expenses are being ignored
• little to no growth, rarely organic, not to mention after inflation
• the generation of free (!) cash flows takes a back seat
• the current cash position is not looked at at all
• too optimistic valuations

The most important factor for this crowd has become looking at the past.

As stupid as it sounds.

By assessing a company’s dividend history, i.e. for how long a dividend has been paid or even raised without interruption, is viewed as the single most quality component. For the interested, I discussed the Lindy effect in an older article here.

However, the dividend history is hardly meaningful for the future. At the same time, every cent-wise (or less) negligible increase is celebrated like a ten-bagger.

I want to give you a few examples.

My longer time readers already know the case of V.F. Corp (ISIN: US9182041080, Ticker: VFC) – a fashion producer. They were a highly celebrated dividend king that raised its distribution per share for exactly 50 years.

Every year, more was paid out. Until it wasn’t.

Ironically, after having reached this questionable milestone even though the financial health of the company did not allow for it, subsequently the dividend was cut – even twice in the same year.

A more recent victim was Walgreens (ISIN: US9314271084, Ticker: WBA).

Regularly, we could find headlines like these. Even though it’s four years old, this was the standard view of this “high quality” dividend stock.

In the conclusion, the authors wrote (emphasis mine):

When combined with the potential for a major acquisition, there’s a lot of uncertainty surrounding the pace of Walgreen’s future dividend increases and long-term earnings growth. The company should continue to pay a safe dividend, but conservative investors need to have realistic growth expectations and may prefer investing elsewhere until the industry settles into a steadier state.

To be fair, back then the situation was not that dire like over the last twelve months. I think, I do not need to stress too much that the dividend has been cut last month after a series of 48 years of annual increases.

My point is another one.

Since at least ten years already, this business has been in decline. There were serious issues under the hood. For example, let’s look at the development of margins:

Even though sales continued to rise, cash flows were only temporarily boosted by not endlessly repeatable working capital movements, first and foremost higher accounts payable, i.e. paying bills later.

Both are not signs of quality.

The stock has already been in a downtrend since 2015. WBA was one of the darlings with its “proven” business model, operating in an area of everyday needs and with its long dividend history.

What should go wrong with a more than 100 years old business?

It does not make sense to invest in a heavily struggling business without the perspective of improvements and solely focussing on the dividend, because it has been paid in the past.

Or because WBA has been a Dow Jones member which it isn’t anymore as it has been substituted by Amazon (ISIN: US0231351067, Ticker: AMZN).

Although, it was “only” a cut of 48% (after 48 increases), the loss of capital is devastating. WBA’s stocks trades where it was in 1998.

Besides a deteriorating business, WBA also had issues in generating cash flow. As the cash balance was shrinking, it was just a matter of time until the payout would be cut.

This is what Buffett means and I ascribe to as permanent loss of capital.

Who cares that there has been a dividend for so and so long when the underlying business is suffering?

Numerous people will have bought these stocks when sentiment was still good and the stock either at the high or already in decline, because the yield was “more attractive” and “what counts is the dividend, not the stock price”.

Well, it counts for so long, until the dividend gets axed.

The problem is, besides receiving less dividends, you are then also forced to realize that there was a loss of capital, as the main reason for these stocks was the dividend.

The same applies for companies from the tobacco sector, mainly Altria (ISIN: US02209S1033, Ticker: MO), 3M (ISIN: US88579Y1010, Ticker: MMM) with its yearly penalties in the billions or also the telcos like AT&T (ISIN: US00206R1023, Ticker: T) or Verizon (ISIN: US92343V1044, Ticker: VZ).

Another secret sauce was to bet on REITs, because investing in properties without having to buy whole properties was a safe bet. Especially combined with the fact that REITs must distribute certain minimum dividends.

But many were blind to see lofty valuations and a sensitivity to interest rates as well as unfavorably structured debt maturities.

W.P. Carey (ISIN: US92936U1097, Ticker: WPC) certainly was the most prominent example from the REITs sector.

Even thought WPC’s stock has not been smashed that extremely like the examples discussed above, you also have a time travel back of eleven years when comparing the stock prices now and then.

The good thing in this case is that the dividends were high and assuming one reinvested them constantly, the total return was even strongly positive. The question is, with the reduced payout and high interest rates now, is this such a comfortable situation for an investment or do risks prevail? What one should also factor in is the constant share dilution due to equity raises which is a topic on its own.

One has to discuss all aspects instead of sugarcoating.

When advertising the positive psychological effect of investing, the negative one of dividend cuts AND loss of capital often at the same time should be discussed, either.

That’s what I am missing.

I honestly even find it more difficult to apply what I wrote last week (see here) about quitting at a loss when using the dividend strategy blindly by only buying accordig to dividend histories. In brief, I described a sweat spot around –25% to –30% to take the loss in order not to let it grow too much, because the required gains grow disproportionately, just to come back to zero.

With this dividend investing strategy, where stock prices are seen as irrelevant, the majority won’t drop out and take a breath before deploying capital elsewhere to gain back the loss.

Dividend cuts in many cases also come after the stock has dropped already heavily.

As these bought stocks are often little to non-growing businesses and not seldom with little debt, it is quite unrealistic to gain back a loss of –50%, where a double is needed. How many years shall one wait while collecting dividends with a yield of say 4% or 5%?

These are limitations and serious flaws in this approach.

While it is true that such portfolios often are not concentrated and the loss of one stock does not weigh too much on the overall portfolio, one with lots of garbage does not balance that out. There are many highly leveraged, barely growing businesses that enjoyed tailwinds since the 1980s when interest rates were declining. But also demographics, offshoring, cheap labor, etc. played a role.

This is not the case anymore.

Another anomaly I observed is that energy stocks in many cases do not become parts of such portfolios. The main reason is due to their cyclicality and not stable cash flows.

Had the homework been done properly, the results would have been that many energy companies have clean balance sheets, are producing everyday’s necessities, have way more robust cash flows than in the past and they also have nice dividend series (for those who rely on it).

For example, TotalEnergies (ISIN: FR0000120271, Ticker: TTE) has been paying an at least stable dividend since the 1980s. Exxon Mobil (ISIN: US30231G1022, Ticker: XOM) has grown its dividend by more than 5% annually for 41 years (see here).

Even though I do not own any of those and I als did not publish any research report about them because I presented to my members other energy picks which did pretty well so far, it would make way more sense to put such stocks in a dividend portfolio than the above proclaimed safe ones.

Another one of these and certainly a candidate for a coming cut is the dividend king Leggett & Platt (ISIN: US5246601075, Ticker: LEG). The company produces household stuff and has raised its dividend 52 times in a row, as it writes on its page.

However, this is a cyclical business which is criticized when discussing energy companies, but not here. Sales were down by 8% for the last year and are projected to decline further this year.

Margins are under fire, too, interest expenses are going up due to not-little leverage of more than 3x net debt to EBTIDA and breathing room becomes scarcer.

Even though for now the dividend of 240 mn. USD p.a. should be safe (it was raised last year), because it’s covered by last year’s free cash flow of 380 mn. USD, there was a positive working capital component of 50 mn. USD and as said this year will be tough, again.

You can see for yourself what the market thinks about this “safe” 9%-yielder:

Debt is breaking their neck.

You can also take many utilities with their great dividend series, but negative cash flows and rising cost of debt as an example. This is also a favored sector.

In order not to let this article become too long, I’ll leave it with this. I think my message is clear.

That’s why I am filtering my stock ideas for my members strictly.

Permanent loss of capital is what I am looking to avoid. It is not entirely possible to never have a loss, but it is possible to pull the plug in time and to look for positions with a favorable risk-reward, instead of relying just on the past.

Conclusion

The quality of dividend picks has declined.

Important factors are being ignored and the risk of permanent loss of capital increases dramatically when being blinded only by the history.

What worked in the last 40 years in an environment of falling interest rates and other favorable tailwinds, will likely be challenged now.

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