Buy the business, not the market: That’s been my message since the first issue of Utility Forecaster in March 1989. It’s meant staying invested despite gut-wrenching volatility, such as the historic crash/recession/credit crunch of 2008-09.
And I’ve misjudged prospects of individual companies as well, such as American Superconductor (NASDAQ:AMSC) earlier this year. At such times there’s nothing to do but take the loss and move onto something more promising. But following the strategy has consistently built wealth, cycle after cycle. Admittedly, sticking to a buy and hold strategy is as difficult now as it’s ever been.
A nearly unanimous consensus has emerged among economists, investors, politicians and media personalities that the world is headed for a recession at best, and very likely a market catastrophe even worse than 2008-09.
Many investors have decided they can’t afford to risk that by staying in the market. Such extreme sentiment is typical in times of exceptional volatility.
Unfortunately, unlike in years past, investors have literally no alternatives to dividend-paying stocks. Traditional savings investments pay a percentage point or less. Bonds are worse, with only the exceptionally risky dishing out anything close to a decent yield.
If you live off your investments, you literally can’t afford not to own stocks. The commitment has to be for more than a season, in order to capture needed income and avoid punitive taxation.
Know the Risks
Fortunately, following a few simple rules will limit your portfolio’s volatility and, most important, dividend risk. The first is to know your companies.
A high current yield can be a jumping off point for further study. But it should never be the only reason you buy a particular stock. Rather, look for companies that clearly can maintain and preferably grow dividends over time.
Some readers justify holding a riskier, high-yielding stock on the grounds they’ll still get a big return even if dividends are cut. Reality is weakness often begets more weakness in a slow-growth environment like this one. Unless a company is clearly turning the corner, odds are the first cut is a warning of worse to come. And dividend cuts always trigger selling. A 10 percent yield cut in half is still 5 percent. But if the stock falls just 5 percent in response, total return is zero.
In contrast, stock prices always follow a rising payout over time. Dominion Resources (NYSE:D), for example, has raised its dividend by 52.7 percent over the last decade. That’s basically in line with the 70 percent increase in its share price, despite some jagged ups and downs along the way.
Even the strongest company can stumble. The real damage in any bear market comes from the handful of companies that truly implode as businesses.
Keeping up with the quarterly numbers, financing needs and regulatory developments is step one to avoiding a lot of pain. Step two is portfolio balance.
If a stock that’s 5 percent of your portfolio falls in half, you lose just 2.5 percent. But if you have half your portfolio in the same stock, you lose a quarter of your wealth.
Worse, overloading can create an emotional bond between investor and stock, making it impossible to exit if things don’t go your way. Some will commit the cardinal sin of averaging down, raising portfolio risk even more.
The antidote is to never average down and to pare back winners every three months, re-deploying funds to entirely new positions.
One unemotional way to buy good stocks very cheap is to enter “buy limit” orders at prices well below current levels. You’ll only buy if the price set is reached. That may take a while, and you’ll need cash on hand. But if your price is hit, you’re guaranteed a screaming bargain. Just ask those with buy limit orders for 30 or lower on Mar. 15 for Enterprise Products Partners LP (NYSE:EPD). They’re now up 50 percent-plus, thanks to an intra-day drop to $27.85. Check out my Seeking Alpha article, "What I Look For When Selecting MLPs," for more on EPD and MLP investing.
Aug. 8 and Oct. 4 were also great days to get buy limit orders executed. And as long as macro risks dominate the headlines, we’re bound to see more like them. Of course, a big drop in a stock can be due to real business weakness. If that’s the case, those with executed buy limit orders will have to be ready to exit. But you can limit risk by not putting orders on stocks you already own.
If you’re keeping up with the health of your targets, you can pull your buy limit order long before trouble hits. I also strongly advise investors not to use stop-losses to protect positions. It’s likely Enterprise Products fell so far on Mar. 15 because a mountain of stops was hit. Those investors took huge losses and were hit with commissions and probably taxes, even as buy limit orders scored big.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.