My Fear As A Dividend Investor

by: Tim McAleenan Jr.

Here's a passage from Dolores King titled "Smaller Dividend Checks Throw Some Off-Balance" that appeared in the February 13th, 2001 edition of The Boston Globe:

"As part of the third generation in her family to own AT&T stock, and with an aunt who had worked for Ma Bell for four decades, Priscilla Buchanan, 68, once viewed the company as a bedrock investment.

"Mom, apple pie and AT&T, it used to be," said Buchanan, who lives in a Boston suburb. "Not anymore."

No more indeed. As shareholders of AT&T are finding out, their quarterly dividend payments will reflect an 83 percent cut -- the first such cut in the company's 125-year history. It's definitely not the same old Ma Bell anymore.

Buchanan doesn't own enough AT&T now, only about 150 shares, for those dividends to add up to much. But as a retiree, she does rely on quarterly payouts from some of her other investments, such as utility stocks, for income.

AT&T -- once the most widely held company in America and the epitome of a "widows and orphans" stock for its reliable, sizable quarterly dividend -- is not alone in cutting its dividend.

Joining Ma Bell in recently slashing or suspending the regular cash payouts that people on a fixed income have traditionally relied upon: J.C. Penney (NYSE:JCP), Pacific Gas & Electric, Xerox (NYSE:XRX), and banks like BankOne and First Union."

That's my worst fear as a dividend growth investor-that I will spend five, ten, fifteen years buying shares of a blue-chip firm like Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) only to reach the end of the line and experience a dividend cut, elimination, or company bankruptcy after years of diligent saving and reinvesting dividends. We think of firms like Coca-Cola (NYSE:KO), Pepsi (NYSE:PEP), and Procter & Gamble (NYSE:PG), saying, "Oh, that will never happen." But if you talked to an income investor in the 1960s or 1970s, they would have said the exact same thing about AT&T.

But here's the good part - because I am able to identify that which I want to avoid the most (the loss of a dividend), I can then craft a strategy that takes my concern into account so that I can come up with an investing plan that creates what I desire: a dividend stream that grows during every year of my investing life.

Here are four things that I would do to try and avoid finding myself in a position where I could get seriously hurt by a dividend cut:

1. Diversify - Back when I was a pitcher in baseball, I remember what would happen if a particular opponent had been killing me that day. My coach would say "Take the bat out of his hand" and show me four fingers, indicating that I should go for the intentional walk. Well, a good first line of defense is avoiding trouble before it starts -not allowing myself to become too reliant on any stock holding such that the decline of one firm's dividend would pose a significant hardship for my long-term income goals. Most of us seek passive income because we no longer want to become reliant on an employer to meet our needs. I don't want to put myself in the position of needing the income from a Johnson & Johnson (NYSE:JNJ) dividend the way that most Americans need paycheck income from their employer. If I own twenty five or so stocks across the spectrum, then I can afford a dividend burn-out or two and still see my income rise that year. Every one has their general rule for the proper level of diversification, but mine would be this: "I am too beholden to a company's Board of Directors the moment that the loss of a particular dividend is not something I could realistically replace with fresh cash or income growth from other holdings within a year or two."

2. Check for Debt - One of the coolest things my grandfather ever said was this: You can't go bankrupt if you don't owe anybody anything. Debt can cripple otherwise healthy firms. I just stay away from it. For instance, Kellogg (NYSE:K) is an excellent company. But they have about $6 billion in debt, plus the $2 billion in debt financing to carry out the Pringles acquisition. The cereal and snack company will most likely be fine, but if I can find companies that have the same earnings quality without the high amount of debt, why not take that route? The less things that can potentially go wrong, the better.

3. The Technology Killer - Kodak was once a blue-chip stock. The New York Times (NYSE:NYT) was once a blue-chip stock. Cable companies like CBS (NYSE:CBS) once boasted some of the strongest moats in corporate America. But technology altered the landscape for each. People can pull out their Apple (NASDAQ:AAPL) iPhone and take a picture and send it to friends in an instant. You can go online and read most of the daily news for free. There's hundreds of channels on television. And so on. That's why I try to find firms that get stronger with technology, not weaker. Firms like Coke and Pepsi can use technological advances to make their distribution networks more efficient and squeeze out more future profits-it's hard for technology to displace the experience of eating chips and drinking soda.

4. Threats To Earnings Growth-This is the part that can require significant diligence. Is a new firm stealing market share? Are the products of the company that you invest in going out of favor? Is there pressure from generic brands, as is the case with Procter & Gamble, that might force the company to lower profit margins to stay competitive?

Buy-and-hold dividend investing will always be buy-and-monitor dividend investing. Times change. If I could go back in time thirty years and tell my grandfather that in 21st century America, people who smoke in public will be considered social outcasts while the people who do not smoke will be considered "normal", he would have taken another puff and then called me crazy.

But there is much for dividend growth investors to be optimistic about: we do not need a perfect dividend growth record over our investing lifetimes to be successful. If we regularly set aside at least several hundred dollars per month for dividend growth stocks for 20-40 years, then we only have to be right about as often as weathermen to do quite well. I mentioned above that my fear is that I will spend years and years buying shares of a stock and reinvesting dividends only to experience a dividend blowup during my end game, but that is only problematic if I let that particular dividend stock become too large of a percentage of my annual income. If I never allow one company to account for more than 5% of my yearly income, then I can benefit from the miracle of long-term dividend growth without letting my fear of a substantial dividend blowup come to fruition. You can't give up a home run if you take the bat out of your opponent's hands.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.