Why I Hedge Dividend Stocks To Avoid Panic Selling

Includes: GE, HTS, KO, T
by: Todd Johnson

Investing can be emotional for retail investors. It's difficult to own stocks when they are dropping in value day after day. I, as a simple human, share these same emotions. I attempt to prevent these negative emotions via four core strategies. These strategies include 1) reinvest the dividends; 2) hedge the downside risk; 3) own the right stocks at the right time; and 4) prune out the losers. The overriding goal is to make money, sleep well at night, and own a dividend portfolio with a high yield relative to risk.

Reinvest the Dividends

I love nothing more than to invest money into a blue chip stock at a good price. An example is The Coca-Cola Company (NYSE:KO). Coca-Cola is the number one sugar water, and bottled water seller on the planet! This is a business I can understand.

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Berkshire Hathaway has owned 200 million shares of Coca-Cola for a couple of decades. The company is the bluest of blue chips. The yield is 2.7% and likely currently extended due to a pending two for one split. Free cash flow, dividend increases, and stock buybacks are a key part of the capital asset allocation plan.

I recommend taking Warren Buffett's strategy one step further and reinvest in additional Coca-Cola shares. The company has a low beta, high earnings predictability, and a recession proof business model.

These shares should represent the backbone of a dividend income portfolio. The price of reinvestment into new shares should be chosen at the comparison of other stock valuations.

Hedging Downside Risk

I believe in buying insurance, also known as "insurance", on specific stocks. As an investor, we insure our life, we insure our home, we insure our car, and we insure against natural disaster. My thoughts are one should insure their dividend income portfolio through portfolio insurance too. This can be stock specific or industry specific protective put options.

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For example, assume I owned 100 shares of AT&T (NYSE:T). As AT&T is trading at $33.62, I would want to own a T July 2012 32.000 put (T120721P00032000). This protective put protects the AT&T shareholder from the shares falling below $32 per share through the put, through the third Friday of July.

What we can "learn from hedging", per a May 15th article, is invaluable. Strange twists and turns happen in the market. Let's hopefully learn from the past to prevent portfolio calamities.

Owning the Right Stocks at the Right Time

In my view the right stock to buy right now is Hatteras (NYSE:HTS). Hatteras borrows at short term rates and invests in longer duration Government Sponsored Entity (NYSE:GSE) (e.g.., Freddie Mac) mortgage backed securities (MBS).

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Hatteras, via a repurchase agreement with a prime dealer, obtains the funds to purchase GSE MBS. The GSE MBS, due to an implicit guarantee with the U.S. Federal Government, closely tracks the Treasury Bond yields.

The above chart shows the spiraling fall of the Treasury Bond yields. This indicates the 5 year, 7 year, 10 year, 20 year, and 30 year GSE MBS yields are declining and the paper value is increasing. There is a direct inverse correlation between GSE MBS yield rates and MBS valuations. The winners are Hatteras and other mREITs with GSE MBS.

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For the past 5 year - and this crucial - Hatteras has outperformed the SP500 by 14.3% per year. This assumes dividends are not reinvested. My point is investors can make money in a conservative fashion but it won't be on the News at 5:00 pm.

Prune Out the Losers

General Electric (NYSE:GE) is a business which can not compete with the SP500. There is a reason why the company has not paid any Federal taxes. Per the 15, 10, 5 year charts, GE has underperformed the SP500. This is not a stock for an investor hoping to beat the averages. If the stock can not outperform the SP500 over 15 years, then I would argue it is time to sell GE.

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In my opinion - and what I actually do - is toss out a GE. I replace it with a fast growing company like blue chip Visa (NYSE:V). Visa is growing significantly and is not debt burdened. I argue GE is a company for investors who reminiscent about the past. Investors should look toward the present and the future. Visa is investing in and benefiting from every new mobile payment option. Visa has revenue growth, dividend growth, and overall better performance than GE.

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Every dividend investor knows their risk threshold. Investing is enjoyable and rewarding when one develops a game plan with their investment portfolio. I personally advocate hedging to assist in reducing the maximum pain on any one security.

The goal is to make money. If buggy whips were still in fashion, then I'm confident that we would own the number one buggy whip provider. General Electric has lost its way. Invest in blue chip companies with better balance sheets and better growth prospects. We are not cookie cutter investors. We can think for ourselves. Let's get to it.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in HTS, V, KO over the next 72 hours.