Temptations That Dividend Investors Need To Resist

Includes: BAC, KO, MCD
by: Integrator

The road to building a dividend income stream can be littered with things that can take you off track. My own dividend income journey thus far has been filled with a number of missteps. I'm going to detail some of the major mistakes that I made and the ways that I probably could have avoided them.

Chasing yield vs a focus on earnings quality

During the 2008-2009 recession, I was held in awe by the seemingly ever increasing dividend yields that were on offer from the likes of Bank of America (NYSE:BAC) and Citi (NYSE:C). As the price of these stocks were further and further hammered, I couldn't resist loading up more and more on these stocks under the mistaken impression that given they had paid out dividends, and raised these dividends consistently for a number of years that these dividends would be safe and secure.

Had I looked a little beneath the service at how the earnings were being derived and the quality of the loan generation I probably should have realized the slip in standards and questioned the quality and the repeatability of these earnings.

No doubt in response to the likelihood that these earnings and dividends were at risk, yields on the likes of Citi and Bank of America ballooned beyond 7%, indicating a high level of uncertainty given that these companies had never been priced on anything like that sort of yield historically.

I learned a valuable lessons that when a dividend payer is being priced at a significant premium to historic yield, this can be a definite warning sign that warrants further investigation, no matter the track record of the company in growing its earnings. Very high yields are something to be wary of.

It also served to highlight that companies with high earnings quality deserve a permanent place in a dividend investors portfolio, as these are dividends that you can generally bank on year in year out.

The advantage with companies such as Coca-Cola (NYSE:KO) and McDonald's (NYSE:MCD) is that there is no differentiation in product sales based on who you sell to. These sales generally don't haunt you several years later because they were substandard in the first place. I've owned Coca-Cola previously, but after my most recent purchase, I don't intend to ever sell it again.

Running after a special situation

When news broke around the crisis in the Gulf of Mexico and BP's role, I rushed headlong into picking up shares as the price fell, not realizing it would be sliced progressively further and further downward.

Ultimately, it was evident that there was significant value in BP from the perspective of a dividend investor. However what was not initially clear was the full impact of damage and the subsequent reduction in share price that would occur near term.

BP dropped more than 50% in value as the full impact of the damage in the gulf became quantified and assessed. Clearly there was some element of panic and irrationality from the market, but the fact remains that BP's share price still remains well under the levels it was prior to the Gulf of Mexico spill. Investors would have had many attempts at the cherry to acquire BP at reasonable values.

Dividend opportunities that arise from missed quarterly earnings or general news and market noise need to be assessed very differently from more structural impairments in fair value. While special situations can deliver significant uplifts in value, they require a more detailed consideration and assessment.

Sticking too long with a fading star

It easy to get lulled into a false sense of security with a dividend machine that has been churning out earnings and dividend increases year after year.

Consider the example of Avon Products (NYSE:AVP). Avon had experienced close to 22 years of dividend growth prior to 2012, before its dividend was drastically cut.

Avon Products' earnings per share growth and operating cash flow growth had been in decline for several years prior to 2012. While Avon Products' earnings per share were $2.04 in 2008, Avon experienced declines in earnings per share in 2009 to $1.45, $ 1.39 in 2010, $1.18 in 2011, to $-0.10 in 2012.

The natural tendency may well have been to keep riding a winner that had produced such stellar dividend growth in the past, but being able to see the writing on the wall and take corrective action is one of the hallmarks of successful dividend investment.

Selling too early

A less obvious "temptation" is to want to take profits on a solid increase in a dividend stock. In my view, this is a temptation that should be resisted. Top-drawer dividend stocks have a tendency to increase substantially in value over time.

There is this virtuous cycle that is in-built for dividend paying companies with wide moats and sustainable competitive advantages giving rise to increasing profitability, cash flows and rising dividends.

Over time, this virtuous cycle can lead to sustained wealth accumulation. During this process of progressively increasing stock prices and wealth accumulation, there can be a temptation for investors to look to take some profits and cash out on the ride up.

Consider the example of McDonald's stock. An investor who invested $10k in McDonald's stock in 2003 would have almost $80k worth of stock today. Along the way, with the spikes in Mcdonald's stock, an investor would have had numerous opportunities to cash out and reinvest those proceeds into the S&P 500.

However, looking back an investor who did so would probably be kicking themselves for the loss in potential returns that they would have experienced from following such a strategy. While a $10k investment in McDonald's 10 years ago would have turned into almost $80k today, a similar $10k investment into the broader S&P 500 basket would be worth approximately $22k today.

Fortunately, I can't complain of a lost opportunity cost of anywhere close to that amount, although an earlier investment of mine in McDonald's just a few years back has since doubled in price. Needless to say, I sold way too early and missed the run up there.

Dividend investing can be a long and fruitful journey for investors. Being able to recognize and avoid certain negative temptations can make it all the more profitable.

Disclosure: I am long BP, MCD, KO. 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.