Dividend Stocks, Silver, And Safety

Includes: CL, IBM, KO, PEP, PG, T, XOM
by: Tim McAleenan Jr.

One of the reasons why some investors turn to hard metals such as silver is because of its perceived safety as an inflation hedge and store of value. In some cases, investors get spooked by the natural volatility inherent in stock market investing, and so they turn to a hard asset such as silver with the aim of smoothing out the ride.

One interesting thing worth keeping in mind, though, is the fact that silver can be far more volatile than the prices of most blue-chip stocks, even in the short term.

Per USA Today Finance:

Since the commodity market peaked in 2011, and the S&P 500 has rocketed roughly 50%, the value of silver has fallen by 53%. And that's not the only time the silver metal has wiped out. Between its high on Jan. 1, 1980 through its low on June 21, 1982, the price of silver declined a crushing 90%, says Ken Winans of Winans International.

So if investors bought into precious metals, thinking they were somehow safer than stocks, that hypothesis was seriously flawed.

Compared to high-quality stocks, the commodities market can be far more volatile. From 1980 to 1982, silver fell 90%. Anytime I consider a potential investment, I ask myself: How can I cope with this potential investment during the "worst" days of the strategy? If the price of your metal falls by 90%, you receive no consolation. The only potentially intelligent courses of action that you may take are (1) to hold the silver until the price recovers, or (2) escalate your commitment to silver by buying more while the price is low. Unfortunately, there is nothing you can passively do to benefit from the lower silver prices-silver can't pay you a dividend, rent, or interest.

In contrast, I want to talk to you about something known as "dividend yield support theory" that exists with high-quality dividends stocks where the dividend payout is believed to be safe.

When a company pays a solid dividend, there is an informal floor to how low the company can go. As long as Coca-Cola (NYSE:KO) is still chugging out profits, it is highly unlikely we will ever see a world where the company pays out more than 10% in annual dividends.

In fact, if we use The Great Depression as our model for "worst case scenario" with high-quality dividend stocks. In the case of Coca-Cola, IBM (NYSE:IBM), AT&T (NYSE:T), and Procter & Gamble (NYSE:PG), each of those companies had dividend yields of between 7.0% and 10.5% during the market low of The Great Depression. This makes it highly unlikely that these types of companies will experience the kind of 90% decline seen in the silver market between 1980 and 1982.

Of course, the advantage of applying sound dividend investing principles is that such a decline would be welcome if you focus solely on the long-term earnings power of your company (and the dividends generated by them) during moments of severe price declines. The best-kept secret of dividend investing is the fact that the real long-term wealth gets created when you hold on and reinvest the dividends at lower prices.

The appeal of dividend investing is that it turns what is usually the worst part of investing (i.e. steep downward declines) into the best part of investing because you are growing your income faster when you reinvest at lower prices, and you are also increasing your share of the earnings that the company chooses to retain.

There is probably the most important thing I have to say about the difference between non-productive assets like silver and something that generates dependable cash like a dividend stock: with a productive asset that pays dividends, you will always be receiving value regardless of the stock price at any point in time. With a non-productive asset like silver, you are solely reliant upon the market price to determine your future returns.

Exxon Mobil (NYSE:XOM) is going to pay a $0.63 quarterly dividend regardless of whether the stock price is $50 or $130. That is because the company is going to generate $8 per share in earnings this year (assuming the mean analyst projections are loosely correct), and you are going to receive a share of profits regardless of price.

I like to put myself in the position where it is "tails I win, heads I don't lose." That's the joy of buying a high-quality dividend stock at fair value or less. If the price of Exxon stock advances while I own it, I can make money if I choose to sell. If the price of Exxon falls to $60 (without a commensurate decline in the company's earnings power), then that $0.63 quarterly dividend will grow my income at a faster clip. That's why people buy-and-hold quality companies: when the price goes up, you have the option to take a profit. When the price goes down, you can grow your income at a faster pace by reinvesting the dividends.

Companies like Colgate-Palmolive (NYSE:CL) and PepsiCo (NYSE:PEP) did not even lose half their value during the financial crisis of 2008-2009. That's a decent estimate of what can happen to price fluctuations during a realistic worst case scenario. And if you're in your early 30s or older, and you happen to be reading this, silver has declined by 90% in your lifetime. That's the problem with non-productive assets: they may not offer the safety you think. But most importantly, an asset like silver does not do anything that allows you to take advantage of the 90% decline. A company like Exxon, in contrast, will grow your income even faster during periods of share declines if you elect to reinvest the dividends. That's the safety that high quality stocks offer that investments like silver do not.

Disclosure: I am long PG, IBM, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.