DGI Investors have bought into the idea that most companies with long records of raising dividends will continue to raise them. This concept was illustrated compellingly in Chuck Carnevale's recent article, "Consider This Strategy to Reduce Stock Market Anxiety." In that article, he suggested that investors need not worry about stock market volatility when invested in twenty stocks selected from the list of S&P Dividend Aristocrats.
Since the trademarked term "Dividend Aristocrat" was devised by S&P to describe a list of stocks that have raised their dividends for 25 years or more, it should have come as no surprise to readers that the graphs Chuck displayed in his article showed a steady increase in dividends year after placid year. Unfortunately, investors who found this soothing at a time when market volatility is rising to unparalleled heights, may be falling prey to one of the classic mental errors that lead to poor investing decisions: survivor bias.
The term "survival bias" refers to what happens when we draw conclusions from a set of data from which all elements which have not lived up to some criteria for success have been excluded.
An extremely obvious case of survival bias is shown by what I noticed at my recently held 50th High School Reunion. Not a single person who attended had ever suffered a fatal heart attack! What a healthy bunch of kids had gone to my high school! Of course, after a moment's reflection you recognized how silly this statement was. The people who did have fatal heart attacks before the reunion could not have attended. And in fact, we learned at our reunion that quite a few of those I had graduated with were already dead.
Unfortunately, when we turn to the world of investing, it is much harder to detect where data used to convince us of the value of some investing thesis has been subject to the same kind of survival bias. For example, it is common for mutual fund companies to brag that all their funds have outperformed 75% of competing funds - without revealing that the fund company has closed down dozens of other funds over the years eliminating many that severely underperformed the competition.
So why mention survival bias here? Because survival bias is what makes relying on lists of successful dividend growth companies, be they "Dividend Aristocrats" or "Dividend Champions," so dangerous. The stocks on the list are the survivors. But a surprising number of companies that used to be on these lists - stocks that at one time had put together decades of dividend growth histories every bit as comforting as those Chuck showed us - have dropped off. And when we turn to examine what happened to those stocks, the comfort we felt after viewing Chuck's charts should quickly evaporate.
Though S&P does not make it easy to find out what stocks used to be in their index, we are fortunate that a complete list of the stocks that were members of the S&P Dividend Aristocrats in 2007 is available right here on Seeking Alpha, in an article published on 2/20/2007: "S&P Dividend Aristocrats: Less Volatility, Better Results Than the S&P 500," written by Eddy Elfenbein.
When I compared the list of stocks that had been classified as Dividend Aristocrats in 2007 against the current list, which you can find here, I learned that fully 26 of the original 59 companies listed in 2007 were no longer included - 44%! I have listed these stocks in the chart below, along with an explanation of why they dropped off the list.
Now, as you can see, not all of the companies were removed because they did not raise their dividends. Five of the 26 companies were acquired or merged into other companies, losing their identity. Some went on to pay dividends. Some did not.
But 15 of the original 59 companies, fully one quarter of them, did cut their dividends, in some cases radically. Many of the worst dividend cuts occurred in banking and financial stocks, which is unsurprising in light of the financial crisis that took place. Twelve of the 2007 Dividend Aristocrats involved in the banking sector cut their dividends in subsequent years, many very steeply. Even now, eight years after the financial crisis, most of those companies are still shadows of their former selves.
The F.A.S.T. Graph below shows you what happened to one of these once proud Aristocrats. First Horizon National (NYSE:FHN) in 2007 could have proudly pointed to a history of more than 25 years of raising dividends, steadily, year after year.
The white line shows the dividend. You would see similar graphs were you to look at Bank of America (NYSE:BAC), Comerica (NYSE:CMA), KeyCorp (NYSE:KEY), Regions Financial (NYSE:RF), Synovus Financial (NYSE:SNV), and U.S. Bancorp (NYSE:USB). Though General Electric (NYSE:GE), which was not purely a financial company, has recovered better, its dividend is still lower than it was in 2007.
Even worse for the investors who had bought these companies to assure themselves of a dividend stream in retirement, the stock prices of these banks collapsed at the same time their dividends were cut, and in most cases have still not recovered. Hence, not only did these investors with a significant stake in these aristocrats that were subsequently taken to the guillotine lose their expected dividend income, they also lost the principal with which they might have been able to purchase stocks that could have ensured that their income stream continued.
Acquisitions, Mergers, and Spinoffs Can Also Pose Problems
Even the companies that left the list because they merged with other companies may have caused unexpected problems for their stockholders. Though an acquisition or merger usually results in a nice boost in share price - unless the merger resulted from an FDIC mandated takeover due to insolvency - for investors in taxable accounts, an acquisition can also result in a forced capital gain.
If the stock has been held for a long time, that gain may be very large - large enough to raise a retiree's income above the level where dividends aren't taxed. This can lower the net income earned from other dividend stocks held in taxable accounts. Forced capital gains may also push the income of wealthier investors over the threshold where monthly Medicare payments increase.
If an acquisition or spinoff results in the stockholder being given shares of the acquiring company, the earnings of the parent company may drop and the investor's income may also suffer as the spun off company may not have a policy of paying dividends. Then, again, they will be forced to sell.
But The Banking Crisis Was Special. Aren't Other Sectors Safer?
You may find it easy to ignore how many ex-Dividend Aristocrats have dropped out of the Dividend Aristocrat list since 2007 because you assume that this was a one time thing due to the unparalleled chaos wreaked by the financial crisis. But this conclusion might be a serious mistake.
That's because every decade or so there seems to always be some unexpected development that wallops a different sector. And it is often hard to know what companies will be engulfed by problems that originally appear to be confined to one sector.
Just a few examples should suffice. Who could have imagined the collapse of retailers twenty years ago, when we were still in the middle of the Malling of America and Amazon was known only as the name of a river in Brazil? Who envisioned the collapse of oil prices in 2014? The latest black swan disrupting markets?
The implications of both of these more recent disrupters are still working their way through the economy. Though Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM) are the only stocks on the current Dividend Aristocrat list that are identified as being in the Oil and Gas business, quite a few other industrial stocks also have large exposures to the decline in oil prices because a significant percentage of their customers are oil drillers and refiners. In addition, REITs that are invested heavily in regions of the company where the economy is dependent on oil may suffer over the next few years. Banks that have lent to oil-related companies may suffer. So will all those institutions and individuals who have invested in the high yielding bonds of the companies associated with the oil patch.
There isn't a sector of the economy that couldn't suffer dramatic losses should some unforeseen factor arise in the future. Do you really think consumer products companies are safe when over 50% of their sales are made in non-dollar currencies outside of the U.S. making them prey to the effects of severe global downturns, to say nothing of political forces beyond our control?
And that doesn't even begin to get into how dependent many of these "safe" consumer product companies are on sales in China, a country where business and tax laws could change in a week, should the autocrats who rule the country decide it was time to drive out foreign businesses.
Yet another issue that could prove a threat to continued dividend payments is that many of the slowest growing companies on the current Dividend Aristocrat list have taken on very large amounts of debt during the past several years when interest rates have been abnormally low. Colgate (NYSE:CL), Clorox (NYSE:CLX), and McGraw-Hill (NYSE:MHFI) are some examples. A serious crisis in the corporate bond market could, conceivably pose a threat to these companies by limiting their ability to refinance debt coming due.
I don't mention these possibilities because I believe they will happen, only to point out that they, and many others that neither you or I have imagined, could happen. And if they did, stocks you now think of as totally safe could go the way those highly rated, elite banks went after 2007.
Some Companies Just Lose their Moxie
It doesn't always take a black swan to destroy a dividend stream. Not every Dividend Aristocrat from 2007 that stopped paying a dividend did so because of the financial crisis. Some companies just lost their ability to grow earnings. Below is the graph of SuperValu (NYSE:SVU), a huge company that acquired many well-known supermarket chains around the country a decade ago. People are always going to need food, right? So what could be a safer investment? SuperValu was not only on the Dividend Aristocrat list in 2007, it paid steadily increasing dividends for 35 years before it completely stopped paying a dividend in 2013 after years of falling earnings.
Investors in SVU not only lost their dividends, they also lost a great deal of the value of the shares they had bought to get that dividend, making it impossible to replace the lost dividend.
Label company, Avery-Dennison (NYSE:AVY), was another company that cut its dividend, which still has not risen back to the level it was at in 2004. The stock price isn't back to where it was in 2004 or 2007 either.
Pharmaceutical companies, Eli Lilly & Co. (NYSE:LLY) and Pfizer (NYSE:PFE), both were on the 2007 Dividend Aristocrats list. Lilly froze its dividend for 6 straight years. Pfizer's dividend as of now is still 12.5% lower than it was in 2008 and for that matter, less than it was in 2007, too. Investors in these stocks did better in terms of capital gains, only because of the huge run-up in the health sector boosted share price despite these companies' dropping (Lilly) or stagnant (Pfizer) earnings.
When You Leave the Realm of these Premium Quality Companies, Even More Long-Term Dividend Growth Companies Eventually Fail to Raise Dividends
David Fish's wonderful CCC lists provide a much larger selection of stocks that have raised their dividends over time than does the S&P, as the criteria for being listed on the CCC list are less stringent. When I looked at the first list of Dividend Champions David Fish published in December of 2007 and compared the 139 companies on that 2007 list to those on the list today, I discovered that 58 companies had dropped off the list in the intervening years. That's 42%, almost half.
Fish's list includes many smaller companies than the S&P list, and many that have less consistent histories of profitability, since the S&P list only includes stocks that were also included in the S&P 500. But even so, every one of the stocks on the December 2007 Champion list had raised their dividends each year for 25 years or more. In one case, that of Diebold (NYSE:OTCPK:DBD), the company had raised its dividend for 60 straight years until it froze it starting in 2013.
Because David does such a magnificent job of documenting the changes to his lists, it is easy to learn why the various stocks have left his index. When I looked at the 58 Dividend Challengers from 2007 that had dropped of the list, I found that by and large, the reasons were the same as what we saw with the S&P Dividend Aristocrats. Many were banks. But quite a few were once profitable companies that lost their way. For example, LazyBoy (NYSE:LZB) and Masco (NYSE:MAS). And investors in these stocks, like those in the stocks we looked at above, not only lost their dividend income, they also lost the principal with which they could have bought other income.
Dividend Growth Stocks with Shorter Histories Are Much Riskier
Until now we were only looking at what happened to stocks with 25 years or more of steady dividend payments. When we look at the companies that have shorter histories of raising dividends, the attrition rate is striking, especially among those with less than ten years of raising dividends. This is clear from the following table which appears on the "Changes" tab of his 2/2016 U.S. Dividend Champions spreadsheet:
And it is worth noting how short a time many of these stocks have been paying dividends. Fully 201 of the stocks on the Fish "Contenders" list currently have only a five-year history of raising dividends. Since these are five recent years, during which the economy was in an expansionary phase during which the earnings of most companies were rising, fueled by the availability of cheap money, it is likely that many more of these new "dividend growth stocks" may soon join the ranks of those that stop raising their dividends.
Conclusion: Dividend Growth Portfolios Will Always Require Careful and Continuous Monitoring
The data you just reviewed should be enough to convince you that the only way to maintain a dividend growth portfolio that continues to pay dividends is to continually monitor your stocks, because there is no guarantee any dividend growth stock will continue to be a dividend growth stock, or even, for that matter, keep paying a dividend.
Just as was the case with the people in my high school graduating class, age is not a guarantee of health. Companies rise and fall. Managements change. And most importantly, business conditions change. The conditions that allowed a company to steadily increase cash flow over the past twenty five years may never occur again.
So Dividend Growth investors can't just buy and hold. They must monitor earnings closely, listen to conference calls, pay attention to critiques that point out problems with their stocks, keep alert to changes throughout the economy, and act swiftly when detecting black swans. If they wait until a company's earnings decline to where they have to cut or eliminate their dividend, the crumbling share price can make it impossible to replace the income lost from those dividends.
This May Be More Effort Than Those Who Take Over Your Portfolio Can Handle
This is where the biggest problem lies for those approaching retirement who invest using a DGI strategy. Because as much as you, personally, might enjoy investing as a hobby, most people don't. So if anything happens to your cognitive abilities - which, unfortunately, is something that may happen to any of us as we get older - the more likely it is that the person who takes over the management of your affairs will not be willing or able to do the work needed to track the status of every stock in your portfolio so that they can sell problem stocks early enough to avoid the loss of dividend income and the accompanying drop in share value that will make it impossible to replace that lost income.
If, like many people, you assume that you can maintain a complex, labor intensive portfolio because you will be able some time far in the future to transition your portfolio into a less complex form, you are depending on a different kind of survival bias: because you are wagering on your own intact survival into that far future, which sadly, is far from guaranteed.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.