While stocks are going higher every day, it looks like there is not end in sight for prosperity. My net worth is in record territory, and so is my dividend income. However, I believe that somewhere down the road, we are going to experience another recession. Since the stock market is usually in a downward trend by the time the economy gets into a recession, this time of economic contraction would mean lower stock prices. As a result, I think that reviewing the lessons from the financial crisis will be helpful. This is in order to avoid panicking and doing something dumb.
The financial crisis of 2007-2009 was one of the darkest periods in US economic history. Millions of people lost their jobs and homes. Investors saw a decrease in their net worths as stock prices plunged. Even the relatively safe world of dividend investing was turned upside down for many. This might sound like a heresy to many fellow dividend growth investors, but there were a lot of solid companies that cut dividends during the worst of times. As a result, even investors who didn't care about stock prices started caring as they noticed decreased dividend checks due to dividend cuts.
New investors are often attracted to dividend investing when they hear stories about how someone with just $10,000 invested in Wal-Mart (NYSE:WMT), McDonald's (NYSE:MCD) or Johnson & Johnson (NYSE:JNJ) 20-30 years ago would be earning a lot of money in dividends, while sitting on a six-figure portfolio. In reality, not all companies that you will purchase over the span of your investing career will do as well as those three companies. On average, however, if you follow a common sense dividend investing strategy that focuses on diversification, purchasing at attractive valuations, selective dividend reinvestment, and thorough analysis of companies, you should do just fine over time. The thorough analysis is important to determine if they have a chance of continuing streak of increases in the future.
Before the financial crisis, many of the dividend growth stocks you would find in the dividend champions or dividend aristocrats lists were financials. Companies like Bank of America (NYSE:BAC) had been able to boost distributions at high rates while also paying high current yields. It was all great until the start of the financial crisis. Investors who held on through the financial crisis saw their income decimated. However, investors who held financials as part of a diversified portfolio that had allocation to other sectors likely saw very little in terms of dividend income decreases.
I went through the list of dividend champions for 2007 and 2008, and noted that cuts were not as extreme as I through they were:
Out of 139 Dividend Champions at the end of 2007, 11 cut dividends in 2008. Not all was bleak in 2008, however, as three other companies were eliminated from the index because they were acquired.
Out of 128 Dividend Champions at the end of 2008, 22 cut dividends in 2009. There were two companies that were acquired at nice premiums, and six companies that simply froze dividends.
Unfortunately, I started my dividend growth investing journey in 2008, right when I launched my site. As a result, I did not invest in many financial companies other than American Capital Strategies (NASDAQ:ACAS), State Street (NYSE:STT), General Electric (NYSE:GE), Toronto-Dominion Bank (NYSE:TD) and M&T Bank (NYSE:MTB). I would assume that a lot of income investors owned financial stocks such as Citigroup (NYSE:C), Fifth Third Bank (NASDAQ:FITB), Keybank (NYSE:KEY), Synovus Financial (NYSE:SNV) and Bank of America prior to the recession. Unfortunately, most of the dividend investors I end up talking to today seem to have become converts after the financial crisis. The ones that claim to have been dividend investors before the crisis often mention only their success stories, but fail to mention their mistakes. It is usually through mistakes that smart investors learn, and adapt, before they succeed in the game of investing. I would be very interested to learn from the experiences of investors who had become dividend growth investors prior to 2006, for example.
Learning from the lessons of the financial crisis will prevent investors from losing money, sleep and sanity during the next economic correction. I learned some of the best lessons because of the mistakes I made. I was lucky in that I always tried to keep a diversified dividend portfolio. I had approximately 30 stocks by late 2008. My position in American Capital Strategies was mostly a current yield play. I did consider some of the banks such as Bank of America and U.S. Bancorp (NYSE:USB), but they didn't look appealing, despite the high yields. I did have the habit, however, of purchasing stocks simply based on the quantitative factors such as rising earnings, dividends and current valuation. I focused on the dividend aristocrats list, looked for streaks of consecutive dividend increases and bought the stock without reading the annual report or much in terms of any external analysis. I have since been doing more thorough research by going through annual reports, presentations, analyst reports and estimates, and trying to guesstimate whether a company will last for the next 10-20 years and raise dividends along the way. I am also becoming more patient in acquiring stock, as I focus more on entry price than before. I am fine missing out on a dividend stock that doesn't hit my entry criteria price because I know I can deploy my cash in other promising stocks that are cheaper instead. I am also careful in not being mesmerized by high current yields.
Many investors know that they should not panic, even if the stocks they own fall by 50% in value, as long as fundamentals are intact and dividends are maintained and raised. In reality, investors are humans that are subject to normal emotions such as fear and greed. Even if you were emotionally prepared for a decline in your portfolio, while dividends keep getting paid, it is easy to panic and sell everything in order to stop the bleeding. Holding on to companies that remain fundamentally sound is the right course of action, although it is a difficult decision when your stock is down 50%. There is some discussion, however, on whether one should sell after a dividend cut or not.
Investors who held on and didn't sell after the dividend cuts for Citigroup and Bank of America learned an expensive lesson. However, any time I read an article on why dividend cuts are not the time to sell a dividend stock, I learn about General Electric and Wells Fargo (NYSE:WFC) in 2009. In hindsight, buying GE in 2009 seems like a no-brainer. However, at the time, it looked as if General Electric could go under, as the company was facing a cash crunch. As an investor, my goal is not to gamble, which is why I am perfectly fine missing out on a 200% gain if that means I am not going to lose 100% the next time I invest. If you still disagree with my thought process, just ask the investors who bought Bank of America or Citigroup after the first dividend cuts in 2008 how their investments are doing.
I personally felt like the world was indeed coming to an end, although I kept adding the money I could afford to set aside every month to stocks. What made me fine was the fact that I had over two years' worth of living expenses saved up in high yielding CDs and a high yielding checking account. While buying stocks during a recession is the best time to deploy cash, one should also be realistic about the limitations of their own personal situation. During recessions, it is much more likely for a person to lose their job and have to liquidate assets in order to survive. If you lose your job, you would not be able to find the cash to deploy at attractive valuations. Having cash come in every month in the form of dividends and interest income does alleviate some of the pain, however. I was also lucky, because dividend growth investing provides you with an advantage in the markets. The advantage is that most dividend growth stocks are mature companies with stable cash flows that allow them to grow while paying a consistently growing distribution to shareholders. Those cash dividends are particularly valuable during a crisis, since it provides investors with dry powder to deploy in quality companies selling at ridiculously discounted prices.
These companies rarely get into trouble unless there is a major change, like the internet was for newspapers and the mail industry. When such companies get into trouble, the last thing they do is cut dividends. It is very rare that dividend growth companies from all industries cut dividends at the same time. During the crisis, the cuts were concentrated mostly in the financial sector. Companies like Johnson & Johnson, Chevron (NYSE:CVX) and PepsiCo (NYSE:PEP) kept raising dividends. My goal as an investor is to minimize losses while maximizing profits. I am doing this by incorporating the lessons I learned over the past six years into my strategy, and also thinking about risks of the unknown in terms of probabilities. By having a plan in place and being prepared for different scenarios, I believe that my foundation will withstand the next several cycles of boom and bust.
Disclosure: I am long WMT, MCD, JNJ, PEP, CVX, WFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.