Put Your Dividends Elsewhere To Hedge Against Failure

Includes: BAC
by: Tim McAleenan Jr.

This past June, I wrote this article on Seeking Alpha that outlined my fear with dividend investing. My concern is this: owning a stock for 10+ years, sedulously re-investing the dividends over that time frame, and then watching the company fall as fast as Wachovia pretty much describes a worst-case scenario. If Dante wrote The Inferno about dividend-paying stocks, that scenario would be the "Ninth Circle of Hell" for income investors.

And that's why I wanted to discuss one of the best policies that long-term investors can pursue to guard against this threat: pool money from income investments into a general fund to redeploy into a separate investment at a later time. Obviously, it can't hurt to use common sense in applying this rule. There's probably no need to go out of your way to divert a $30 check you're receiving through a DRIP Plan, and there is a very short list of companies like Coca-Cola (NYSE:KO) and Colgate-Palmolive (NYSE:CL) that are probably worth breaking this rule for (as long as the valuation at the time of reinvestment is reasonable or better).

A principal advantage of using the "pool the organic income together" approach is that such a strategy reduces the harm caused by a dividend cut or even company bankruptcy. To do a quick case study, I want to look at Bank of America (NYSE:BAC) to illustrate this point. In 1996, Nations Bank, one of the most conservatively-run regional banks in the country, gobbled up Boatmen's Bancshares, a St. Louis-based lending giant with a sterling reputation. Two years later, Nations Bank merged with Bank America to form a seemingly dream financial services investment: a bank that was geographically diversified (hubs in San Francisco, St. Louis, and Charlotte) that each had storied histories of profitability, with none of the merger components ever experiencing a decline in profitability over any five-year rolling period dating back to 1904.

In short, if Seeking Alpha had been a financial website in the late 1990s, many pundits and investors would have touted Bank of America as a "forever investment" without most observers batting an eye. And to be sure, Bank of America seemed to take care of shareholders (by regularly raising dividends and buying back shares) up until the financial crisis hit and the Bank of America management team exacerbated a tough situation by making the disastrous acquisition of Countrywide Mortgage. But the fallout from this bad decision could have been mitigated somewhat by taking the dividends paid out along the way and putting them elsewhere.

Let's check out the consequences for an investor that bought 1,000 shares of BAC stock in 2001 for $25,000 that chose to follow the policy of pooling cash dividend checks together.

When the financial crisis hit, long-term Bank of America investors saw the price of their stock go from a high of $54.20 in 2007 to a low of $2.50 in 2009. Common sense would tell us that most people wouldn't want to see a $25,000 investment rise to $54,200 and then fall to $2,500. This is a terrible situation. But here's the silver lining. If you had pooled your Bank of America dividends the whole time to deploy elsewhere, you would have received slightly over $14,000 in dividends. That's about 56% of your investment that had been returned to you to invest elsewhere. The moral of the story is this: if you get in the habit of making multiple investments, and then taking the income from those investments to make other investments, you can hedge yourself against terrible news affecting one of your holdings.

This is an advantage that is exclusive to dividend-paying stocks. If you own a company that pays no dividend, you are entirely at the mercy of the company's future success. And if the company goes bankrupt, you would have received no benefit over the intervening years of profitability before the company's collapse. When you take a dividend payment from a company to invest elsewhere, you are mitigating the ultimate financial harm that the company can cause you, relative to your initial investment. When you combine your dividend income to form a brand new investment, you have now reduced your risk by "having something to show" for your years of experiencing dividend growth in the event that something terrible happens to one of your long-term holdings. If disaster strikes one of your investments, this strategy can be useful in ensuring that you received some kind of cash benefit to reward you for holding the company during its years of profitability.

Disclosure: I am long BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.