Fallen Dividend Champions: I Still Have No Fear Of A Market Crash: Part 2

Includes: HSY, LLY, LZB, MO, NEA, PBI
by: Chuck Carnevale


Investing in high-quality, blue-chip, dividend paying common stocks is not the risky proposition that many would lead us to believe.

I don't fear market crashes because I have confidence and knowledge about the value of the businesses I own.

A long dividend streak is but one important metric that prudent investors should look at.

Fair valuation, healthy financials and reasons to believe that future opportunities exist are additional important considerations.

Introduction: Why I Do Not Fear a Market Crash or Correction

The title of my first article in this two-part series was apparently considered provocative by many readers. So much so, that it generated quite a number of comments, many of which accused me of being complacent and/or merely deceiving myself and other readers with unjustified bravado. However, I respectfully submit that the readers making those accusations missed the "here's why" part of the first article.

I do not fear a market crash because I've prepared myself emotionally, and constructed my equity portfolios with a focus on financial health and quality, in order to weather those storms when they occur. Moreover, I recognize and acknowledge that at some point in the future it is virtually a certainty that a market crash or correction will happen. On the other hand, I will further argue that it's equally as certain that they will inevitably end. Simply stated, throughout history all bull markets have ended with a bear market, conversely, all bear markets have ended with a bull market. Moreover, historically, at least, for the vast majority of cases, bull markets run longer than bear markets.

But I believe the most important aspect of those historical realities is as follows. I am also certain that you cannot predict or precisely time when either a bear market or a bull market might end or begin. Therefore, I believe it makes more sense to be prepared to ride those events out, than it does to try to hide from them or exploit them. As I stated in the past, I believe that over the longer run, time in the market is more intelligent and profitable than attempting to time the market.

Additionally, the conventional notion that stocks are a risky asset class has been primarily supported and promulgated based on so-called scientific or academic studies. However, I believe the conclusions drawn from these academic works are not unanimously valid, because the universe included in the studies are too general and/or stereotypical to be of true value. Simply stated, I don't believe you can assume that all stocks are the same, and therefore, cannot draw conclusions that universally apply to them all. Just like it is with people, or any other universe, there are many differences and distinctions within and among the individuals comprising the group.

But even more importantly, most academic studies that I have examined are focused on, and their conclusions primarily drawn, based on stock price action over the period of time the study is conducted. To support this contention, I offer that most definitions of risk postulated by Modern Portfolio Theory (MPT) are related to volatility. These would include statistical concepts such as Beta (a.k.a. systemic risk), R squared (the coefficient of determination or regression analysis), Standard Deviation and others, generally related to a measurement of the movement of price.

My primary issue with this approach is that I consider stock price movements more often than not, unpredictable, irrational and emotionally driven. Consequently, as I stated in previous works, I do not consider volatility as total risk, or risk in its own right. In contrast, I believe that an investor's reaction to volatility is where the greater risk resides. Therefore, I contend that the greatest antidote to that risk is knowledge. With the proper understanding and perspective about the inevitable short-term volatility of stock prices, emotionally charged reactions can be avoided or controlled.

I believe the most important insight regarding this topic is through the understanding of the difference between short-term price actions versus fundamental values. The former is erratic and undeterminable, while fundamental value can be analyzed, calculated and evaluated with a much higher degree of accuracy. Consequently, I trust fundamental valuation over price volatility. Therefore, empowered with a strong sense of what my stock is worth, I am capable of refusing to sell a wonderful business for less than it's worth, just because other less grounded investors might be doing so. In other words, unrealized losses cannot hurt me unless I take them.

Furthermore, when investing in high-quality, blue-chip, dividend paying stocks that continue to raise their dividends, even when markets or economic catastrophes are occurring, greatly reduces the temptation to react. Focusing on the more important aspects of my portfolio holdings such as my dividend income stream coupled with the financial strength and health of the businesses I own, allows me to navigate through the storms with little or no stress, or long-term damage. This is not about blind faith, this is about serious analysis and ongoing due diligence.

Before I Continue: Setting the Record Straight

In two of my most recent articles, I focused on investing in blue-chip Dividend Champions or Aristocrats as viable sources of high-quality dividend paying stocks available to fund retirement portfolios. In the first of these two articles found here, I focused on how the current list of Dividend Aristocrats had, for the most part, outperformed the S&P 500 index since 1996. The article generated quite a reaction with over 860 comments, both pro and con.

There were two misunderstandings that generated the greatest negative reactions, and both are worthy of clarifying. Many readers mistakenly assumed that I was suggesting investing in the Dividend Aristocrats as an index of sorts. However, I was actually suggesting that this universe of high-quality, blue-chip, dividend paying stocks with long histories of increasing their dividends represented an attractive and possibly fertile field of potential research candidates. My point is that I would never consider investing in the Dividend Aristocrat universe en masse without evaluating the fundamentals and relative valuation of each specific company. This is simply a universe I presented where potentially attractive, sound and prudent dividend paying equities might be found.

I understand why many readers felt this way, because I presented data showing the track record of each constituent in order to point out how well they performed since 1996. Once again, the fact is that I would never consider investing in any stock without first examining its historical track record, with my primary focus on its operating history (earnings results) and dividend record. Consequently, I presented the record of each current Dividend Aristocrat constituent along with several detailed examples on current constituents with different records, characteristics and merits.

Related to the issue above, many readers mistakenly accused me of engaging in survivorship bias because I reviewed each constituent based on their performance record beginning in 1996 without including companies that fell off the list. However, this was not meant to be a back test of the universe. The primary reason I chose this timeframe was because it was a time when many of the constituents were trading at fair value, and simultaneously because the S&P 500 was also at fair value at that time. To be clear, I was not merely back testing, I was simply measuring the performance of each current Dividend Aristocrat constituent against the S&P 500 at a time when both would be competing on a level playing field of fair valuation or close to it.

Many readers believed it was unfair of me not to include fallen Dividend Aristocrats that were on the list in 1996 in my analysis, and therefore, accused me of engaging in survivorship bias. I consider this unfair because I was only reviewing the current Dividend Aristocrat universe as a potential source of research candidates for investment now. Accordingly, any company not currently on the list for whatever reason, was not a current or active member of the universe I was searching in.

Therefore, in this article I will cover many Dividend Aristocrats that have fallen off of the list in order to illustrate that I would not have considered them for investment, and how and why I could logically come to those conclusions. But perhaps more to the point, the accusation of survivorship bias was offered to disprove that investing in a portfolio of Dividend Aristocrats would not produce as good a record as they felt my article implied. But again, the article was not about the record of the universe, instead it was focused on the records of many of the individual constituents within the universe.

And once again, the article was not about investing in a portfolio of Dividend Aristocrats as an index or as an automatic index-beating portfolio. Instead, the article was about looking for specific individual opportunities within this pre-screened group of blue-chip dividend payers. The fact that the majority of these current Dividend Aristocrats had outperformed the S&P 500 in both total return and cumulative dividend income was simply an interesting observation and a plus. In other words, this was a great list comprised of numerous outperforming dividend paying stocks to choose among.

Furthermore, I was arguing for selectivity and for fairly valued opportunities comprised of companies with excellent long-term dividend records that could be considered for current investment in today's generally high stock market. As a follow-up, in my second article found here, I offered 20 companies that I felt currently looked interesting and worthy of further scrutiny. As I repeatedly point out, it is a market of stocks, not a stock market.

Frankly, I believe that high-quality, blue-chip, dividend paying stocks with long histories of raising their dividends each year are similar to the late Rodney Dangerfield. They simply do not get the respect that they deserve. Moreover, the notion that investing in America's highest quality companies is too risky for retirees is simply fallacious. The risk associated with any individual stock can be mitigated to a reasonable level of risk. Owning a high-quality, blue-chip, dividend paying stock does not imply taking the risk associated with the overall stock market. Each individual company possesses their own level of risk, and can be determined with a reasonable level of accuracy if the investor is willing to apply a little work, effort and research.

There is risk associated with investing in anything, and bonds today are no exception. As I previously stated, not all stocks are inherently risky investments, especially our best large-cap, high quality, dividend-paying blue-chips. When there is high risk with these blue-chip stocks, it is usually attributed to excessive overvaluation. But, when valuation is sound and reasonable I contend that the risk associated with investing in these stocks is significantly lower than many would like us to believe.

Fallen Dividend Champions: For Those Fixated on Survivorship Bias

In order to address my contention that the focus on survivorship bias that many with a penchant for statistical analysis hold and believe is overblown, at least with financial analysis, I will turn to the Dividend Champions list compiled by fellow Seeking Alpha Author David Fish. There are a couple of reasons why I chose to do this. For starters, the vast majority of Dividend Aristocrats are included in the Dividend Champions list. Second, David Fish has been compiling and presenting this list since December 2007, and his work includes the records of any companies that have fallen off of his list since he has produced it.

Consequently, I can use David's good work to review the specific realities associated with companies that fell off his list because of dividend cuts, dividend freezes and other factors such as mergers, spinoffs or acquisitions. However, the primary purpose behind my presenting the following analysis is to illustrate that there were many factors that justify excluding the majority of these names from my dividend growth portfolio. Even more importantly, in most cases the reasons to reject them as candidates was obvious and clearly evident to anyone who was paying attention and/or willing to do a little analysis.

The following table, courtesy of David Fish himself, lists all companies that have fallen off the Dividend Champions list since 2007. Included on the table are the number of years of consecutive increases before they stumbled, followed by the date that they were deleted. Currently, there are 106 Dividend Champions and the table of fallen champions since 2007 totals 56, admittedly a high percentage. I am confident that this fact will delight the many detractors that reject dividend growth investing. However, as I will soon illustrate, there is more to sound analysis than merely pointing at a number on a spreadsheet reveals.

Fallen Dividend Champions since 2007: Performance Results and Comparison to the S&P 500

Just as I did in my previous article, I offer the following F.A.S.T. Graphs™ portfolio review to include the performance records of the fallen Dividend Champions that are still actively traded as individual companies. However, in these examples I only include performance over the past decade (since 2004). Therefore, my analysis covers the timeframe that starts a few years before the Dividend Champions list was created.

There are interesting takeaways that I believe this analysis reveals. First of all, the majority of companies that left the Dividend Champions list were financials. Prudent equity portfolio construction implies not overweighting a specific industry. Consequently, the prudent dividend growth investor might have been exposed to a few financials, but not to an extent that their portfolios would have been devastated.

I also found it interesting to note that several fallen champions that were not financials outperformed the index on all counts. Here I am referring to capital appreciation and total cumulative dividend income. I will present a few examples next. One of my primary reasons for conducting this exercise is to illustrate that just because a company falls off the Dividend Champions list, it does not necessarily follow that it simultaneously becomes a poor investment, nor does it imply that it would devastate a well-designed dividend growth portfolio.

Dividend Champions that Cut their Dividends

A fallen champion most likely to have a material negative effect on a dividend growth portfolio can be found among those companies that cut their dividends. Once again, the majority of companies on this list are financials. The reader should also note that list excludes those few companies that are no longer available because of mergers, spinoffs or acquisitions.

However, as I discussed earlier, the astute and diligent investor should have had ample opportunity to remove these companies from their portfolios prior to maximum damage. On the other hand, the possibility of total loss is not a justified fear, in my opinion. Rarely does that occur, and later I will illustrate that there are typically many recognizable early warning signs that can alert those investors that are prudent enough to continuously monitor and research their holdings.

Pitney Bowes Inc. (NYSE:PBI)

My first specific example from the above list of companies that cut their dividend is Pitney Bowes Inc. My purpose in showing this example is first of all to illustrate that this company was significantly overvalued prior to fundamental deterioration that eventually led the company to cutting its dividend. Consequently, the prudent valuation-oriented investor would have rejected this company based on its overvaluation alone, and therefore could have easily avoided the future disaster.

Due to the significant weakness with this company's earnings achievement since the Great Recession, F.A.S.T. Graphs™ only calculates the fair value reference line (the orange line) at a P/E ratio of 11.8. Consequently, I have utilized the overlay P/E ratio feature of the tool and added a more typical fair value P/E ratio reference line of 15 (the magenta line on the graph) simply to illustrate how overvalued Pitney Bowes' stock was.

La-Z-Boy Incorporated (NYSE:LZB)

With La-Z-Boy Incorporated, the prudent investor exercising proper due diligence practices would have had ample warning that something was amiss long before the company eventually cut their dividend. Earnings starting in 2004 were in a virtual freefall alerting holders to exit before too much damage occurred.

Additionally, a quick glance at the company's balance sheet should have also raised numerous red flags. Important metrics such as assets per share (atps), cash per share (cashps), common equity per share (ceps) long-term debt per share (dltps) and invested capital per share (icaptps) were all deteriorating long before the dividend was cut.

Moreover, a close monitoring of the company's net profit margin (npm), return on equity (roe) and return on invested capital (roi) were also extensively stressed. This particular fallen Dividend Champion was throwing off warning signs in neon.

Dividend Frozen

Companies that froze their dividend were also purged from the Dividend Champions list. However, those that merely froze their dividends were much less dangerous than those that cut dividends primarily due to deteriorating fundamentals. The top 4 out of the 16 companies that froze their dividend significantly outperformed the S&P 500, and I find it interesting that all of them would have produced positive returns since 2004, a period of time that was prior to and after the Great Recession.

The Hershey Company (NYSE:HSY)

My first specific example from the dividend frozen list includes The Hershey Company, the best performing company within the group. In this example, I believe the company was overvalued in early 2004 which would have, and in fact did, preclude me at least from including it in my dividend growth portfolio. On the other hand, for those that are willing to pay a quality premium, it could be argued that the company was fairly valued on that basis. Nevertheless, there was no long-term damage from owning this previous Dividend Champion over this timeframe except perhaps when it became excessively overvalued in 2005.

The performance results associated with the above graph for Hershey speaks for itself. This blue-chip fallen Dividend Champion outperformed on both fronts - capital appreciation and total cumulative dividend income, in spite of freezing their dividend for one year.

Eli Lilly and Company (NYSE:LLY)

My last example from the dividends frozen list looks at the opposite extreme, representing the worst performing company that froze its dividend. However, this particular example was excessively overvalued prior to the Great Recession and only became reasonably attractive as a result. Nevertheless, once it hit fair value (touched the orange line) it could have been purchased with little long-term damage. The dividend was in fact frozen, but still quite generous. Here, I might add that few investors were willing to buy stocks in early 2008, which might have also allowed them to avoid this fallen champion.

Had you purchased this fallen champion even though it was overvalued at the beginning of 2004, on a capital appreciation basis, you would have suffered a minor long-term loss. However, when the consistent dividend income stream is added in, even this worst performing fallen champion that froze its dividend eked out a modest profit. Certainly not a great return, but not a devastating loss either.

Others: Mergers, Spin Offs, etc.

This final portfolio review simply lists additional companies that were once champions that fell off the list due to merging or becoming acquired by other companies, or as a result of spinoffs. Obviously, I could not review the records of companies that no longer are traded.

Altria Group Inc. Inc. (NYSE:MO)

However, I will include the one example Altria, formerly known as the original Phillip Morris Company, to illustrate why these cannot be effectively reviewed with the F.A.S.T. Graphs™ research tool. Several spinoffs created, in essence, a new company. In order to effectively calculate its past record, each spinoff would need to be included. However, this particular company can be reviewed as a standalone entity since 2009. I offer it only for the reader's understanding and perspective.

The following is the longest earnings and price correlated graph that is currently practicable to look at on Altria. This graph reflects the company since they spun-off Kraft and Philip Morris International, etc.

Altria's performance since they have been an independent entity has been significantly above average. Total cumulative dividend income generated is more than three and a half times greater than the S&P 500, capital appreciation was over 20% per annum leading to significant out-performance versus the S&P 500.

Summary and Conclusions

My objective with this two-part series was to illustrate the value and opportunity that investing in high-quality, blue-chip, dividend stocks such as Dividend Champions or Dividend Aristocrats can offer. However, I have not suggested blindly investing in all the companies on any of these lists. A company that has achieved a continuous streak of dividend increases spanning 25 years or more is a powerful and compelling clue to success.

On the other hand, a long dividend streak is but one important metric that prudent investors should look at. Consequently, companies on these lists only represent a starting point or a fertile field of potential candidates prior to a more comprehensive research. Fair valuation, healthy financials and reasons to believe that future opportunities exist are just a few of many other considerations that investors should consider.

An additional goal that these articles were written for was to illustrate that investing in high-quality, blue-chip, dividend paying common stocks is not the risky proposition that many would lead us to believe. All common stocks are not risky investments, especially high-quality, blue-chip, dividend paying stocks that are available at attractive valuations. Investing in quality dividend-paying blue-chips at sound valuation reduces the risk of investing in stocks considerably. Not all stocks are the same, and therefore, not all stocks should be looked at as universally risky. Some are, some clearly are not, it is the job of the prudent dividend growth investor to make those distinctions and invest accordingly.

As a result, I don't fear market crashes because I am complacent or because I've buried my head in the sand. I don't fear market crashes because I am prepared to walk through any future valley that may result from a temporary drop in stock price because I have confidence and knowledge about the value of the businesses I choose to invest in. Therefore, the only way that I believe a market crash or correction can hurt me is if I panic and sell valuable assets for less than they are worth. Comprehensive research and due diligence protect me from making such a devastating mistake.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: The author is long MO, BBT, GE, JCI, PFE. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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