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Portfolio strategy, dividend investing, REITs, value
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Back in the mid 90s it was common for individual investors to own and prosper with index funds. The market was headed straight up and most companies participated in the Clinton administration economic expansion. The index fund party didn't last too long however. A growth stock valuation bubble, 9/11, and a financial meltdown, amongst other events, put the kibosh on index success over the past twelve years as the domestic market sorted through multi-source volatility.

Of course that didn't mean that there weren't individual stock successes. Investors who paid careful attention to valuation, or were frontrunners to some of the big technology breakthroughs [Apple (NASDAQ:AAPL), Google (GOOG}, etc. ...] have been handsomely rewarded, much more so than index investors who waited on a rising tide that ultimately failed to lift a majority of boats.

Looking Ahead

As I have written here previously on SA, I feel the last decade or so will become the next decade on a macro level. My short thesis is that the global economy will remain weak and investors of all types will continue to be challenged with portfolio strategy. In the last decade patient equity growth investors faced an unexpectedly volatile and ultimately stagnant environment, however, if my flat/weak global growth thesis holds true, it may be dividend investors this time around who may be caught off guard.

I don't think all dividend companies will be forced into a corner, but I would expect a higher percentage to slash dividend growth rates as revenue and earnings on a macro level become flat. In this scenario, companies with higher than average payout ratios, debt levels and weak cash positions are most at risk of forcible dividend adjustment. This will create further difficulty as already yield starved investors contemplate their next move in the ZIRP environment.

Past Performance Isn't Indicative of Future Results

A common philosophy amongst many dividend investors is that if you buy perceived quality stocks that have been around forever, you can hold them forever, and reap annual dividend increases. Even during the past challenging decade that strategy has by and large worked, as few companies, even those that have run into earnings headwinds, have had to significantly curtail dividend policy. However, will that be the case if the economy continues its flattish course, or worse yet, slowly deteriorates in the years ahead?

While we can sit around a campfire, hold each other's hands, and pray that things work themselves out over the next few years, I don't think that's a prudent or realistic move. Given the densely foggy economic times we live in, income investors heavy into equities with expectations of inflation-beating dividend growth should start wondering and preparing for what happens and how to react when we run into another decade of broad economic headwind.

Caution Ahead

While it's reassuring to know that a company such as Procter and Gamble (NYSE:PG) has increased dividends for 56 consecutive years, it's more important for a dividend growth investor to focus on whether that streak will continue or come to a screeching halt in a continued challenging business climate.

With a payout ratio that now hovers around 60%, an inability to make price increases stick, eurozone and Asian demand issues, R&D/innovation criticism, and a managerial crisis of confidence, I believe at minimum a yellow flag should be raised on forward prospects for meaningful dividend growth from P&G.

Am I suggesting you all go out and sell PG if you own it? Not necessarily. Personally, I sold out of my position last year on earnings growth concerns and rotated into what I considered greener pastures from a total return perspective. However, at minimum I think the fundamental funk the company faces now raises questions not only about earnings growth but also whether P&G can provide long-term, inflation beating dividend growth.

On the other hand, management has announced cost cutting measures, is facing a potential investment and likely associated nag fest from activist investor Bill Ackman, and doesn't appear to be fiddling like Nero during the current firestorm. So despite my bearish outlook, there is certainly room for an optimist's case as well. I don't personally believe in it, but it is there.

Taking Preemptive Action

With this cursory look at PG as an example, scrutinize all of your equity-income positions and determine if continued macroeconomic headwinds, coupled with lofty payout ratios, and other fundamental factors portend a potential hiccup for the income you derive and/or anticipate going forward. If PG does not get its house in order the next 12-18 months, is it possible management decides to flatline or only nominally increase the dividend? What happens to the stock price as a result? Will you assume that the company will improve its performance because it has in the past, or might it be different this time around? Would it be better to rotate now into a new or existing position with a lower payout ratio, better near-term fundamentals and a rosier long-term outlook, but potentially lower current yield?

These aren't easy questions for an income dependent investor to answer. But my inclination for any dividend growth investor, or any investor for that matter, is to err on the side of caution. Sell, or at minimum start easing out of positions if you see a yellow flag flying above corporate headquarters. In this day and age it is not wise, in my view, to assume that things will get better because they have in the past. The global economy has become unsteady, much more complicated, and is likely to remain that way, a veritable minefield of sovereign and corporate issues. And even well grounded companies with strong brands and leadership can't overcome that which they have little control over.

Financial Strength And Allocation Focus

For investors keen on remaining in equity I would focus on dividend payers with the current financial strength to weather an ongoing flat or bearish economy. Look to companies that possess some or all of these aspects: lower payout ratios, low debt to equity, strong per share cash positions, and a business that appears to be performing comparatively well at present. And of course look to purchase at an attractive valuation. I consider Accenture (NYSE:ACN) a stock exemplary of the above criteria.

In addition, equity investors should reassess their overall allocation and commitment to dividend stocks. Over the past few years, income investors have shifted from bonds to stocks because of starvation in corporate fixed income and basically nil risk-free yield. The problem is that if the economy remains weak and inflation in check, rates would remain low, earnings would founder, and broad based valuations would fall, as well as stock prices. Ergo, the income gained will be erased many fold by paper capital loss. And for those approaching retirement, that could be disastrous.

If you have no other source of cash flow, you need to seriously concern yourself with the risks of holding only stocks. Bonds may not seem like a great investment here, but if my thesis of flat rates and continued attrition or weakening of the economy holds true, fixed income will be a good place to hide from a total return perspective. Even in higher yield debt, an innately riskier space, default rates remain low and payouts much more attractive to cash. Given the low rate environment however, I would keep maturities short; you don't want to be caught with your pants down in a rapidly rising rate scenario, unlikely in my mind, but still possible.

The Bottom Line

Caution is the catchword of the day. And I think the current global macroeconomic landscape provides reason to invest with extreme prudence, not reckless abandon. While I'm not keen on pessimism, if I see a black cloud on the horizon I need to prepare for the worst and hope for better. Income investors can still succeed in this environment, there just needs to be more thought put into individual risk tolerances and security evaluation. Dividend and income opportunities certainly won't disappear, but growth and reliability may slowly evaporate or shift.

Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.

Source: Dividend Risk In Another Lost Decade