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The Dividend Investor's White Lie: All I Care About Are Dividends

Includes: O, PEP, PG
by: Reuben Gregg Brewer

Dividend stocks are still hovering around all time highs, despite some pullbacks.

Many dividend investors are telling themselves that price doesn't matter.

If that's you, take the time now to prepare to live by that statement or you could end up buying high and selling low.

"I don't care about the stock price, all that's important is that the dividend keeps getting paid." That's a paraphrase of the refrain from a large number of readers to my articles in which I warn about extreme valuations. It's also the little white lie that many dividend investors tell themselves to justify buying into an expensive stock. And when push comes to shove, and prices start falling, many investors find they do care about price. If you think price doesn't matter, try these mental games on for size.

The bear game
Downturns come in many different sizes. Let's play a game with declines of 10%, 20%, 30%, and 40%. And we'll look at Realty Income (NYSE:O), Procter & Gamble (NYSE:PG), and PepsiCo (NASDAQ:PEP). This trio yield around 3.8%, 3.1%, and 2.9%, respectively, and are all trading around their all time highs.

With a recent price of around $64 a share for Realty Income, a 10% decline would lead to a price of around $57.50. The current dividend is about $2.42 a share per year. So, roughly speaking a 10% decline would wipe out a bit more than two years worth of dividend payments. That might not be so bad, if you expect the dividend to keep getting paid.

But a 20% decline takes the shares down to about $51 dollars, or over five years of dividend payments. A 30% drop suggests a share price of $45 dollars, or nearly eight years of dividend payments. And a 40% drop indicates a stock price of around $38.50, or roughly 10.5 years of dividend payments.

If you think these numbers are unrealistic, think again. Realty Income is already over 10% off its recent highs. It could easily go much lower if history is any guide. The real estate investment trust fell over 25% leading into 2000 and dropped nearly 45% during the worst of the 2007 to 2009 recession.

Perhaps you could sit back and hold through such a massive decline, but a lot of people have to be sellers for a stock to fall like that. And trust me, it's hard to sit tight when you watch your net worth get cut in half because of price declines. You start to worry more about how you'll ever make that kind of money back and far less about the dividends you're getting. That's especially true the older you get, since you have less time to bounce back from a catastrophic loss.

Yes, regular dividend payments can help you stay the course in troubling times, but only if you are well prepared emotionally. For example, are you going to take that trip of a lifetime you were thinking about if your net worth went from a million dollars to $600,000? Heck, in the face of that kind of loss you might think about canceling a trip, flying coach, to visit the grandchildren or go so far as reducing the number of times you eat out.

In the face of that kind of fear, would you have the stomach to stay with a stock that's seen a 40% decline? Because, when it gets that bad, it feels like it can only keep getting worse. And, believe it or not, you will probably feel physical pain when you think about your portfolio.

More fun
Now consider P&G, which has recently been trading hands at around $86.50 and has a yearly dividend of around $2.68. A 10% decline would take the shares down to $78, a little more than three years worth of dividends. A 20% decline would reduce the price to $69, or nearly 6.5 years worth of dividends. A 30% decline would lead to a price of $60.50, just over 9.5 years worth of dividends. And a 40% decline would suggest a price of about $52, or almost 13 years worth of dividends.

Could you sit back and watch P&G's shares fall so much that you'd give up 13 years worth of dividend payments in capital losses? The easy answer is to say you'd step in and buy more! But that's a lot easier said than done, especially if you don't sit down and really put some math to the numbers. And perhaps pen to paper, to help remind yourself when panic sets in that what you want to do is buy while others are selling-not follow along with the crowd and run scared.

How about PepsiCo? The soda and snack giant is trading at around $104.50 and has an annual dividend of $3 a share. A 10% decline would bring the price down to $94, which would be about 3.5 years worth of dividend payments. A 20% decline would lower the price to around $84, a loss that equates to nearly seven years worth of dividends. A 30% decline would mean a price of roughly $73 a share, about 10.5 years of dividends. And a 40% fall would mean a price of just under $63, about 14 years of dividends.

Going against the crowd
Clearly you get the point and could easily play this mind game with any stock you own or are considering owning. When times are good, it's easy to sit back and say you will hold no matter what. But that becomes a lot more difficult when you are faced with the emotional duress of watching a stock you own fall.

And when you compare the price decline to the years of dividends it would take to break even, it puts a different face on the issue. For example, would you be willing to give up 14 years worth of dividend payments to hold on to PepsiCo through a 40% stock decline? Before you say that such a price drop isn't possible, remember that the current low interest rate environment is way outside the norm and represents a massive amount of intervention by central banks-who really don't know what the potential outcome is going to be.

In isolation you might be able to sit tight with a single stock falling. But nothing ever happens in isolation. The game I've been playing will be accompanied by massive market losses (most if not all of your holdings will be involved), the media telling everyone that the financial world is coming to an end (that's hyperbole, but it will feel like the truth), and some event (in hindsight) we all should have seen will have "caused" the crash.

There's a reason why so many famous investors, like Benjamin Graham, talk about emotion being such a big part of the investing process. If you are investing today, you need to prepare yourself ahead of time for the bad times that are inevitably around the corner. I don't know when, but I do know that all bull markets throughout the market's history have been followed by bear markets. This time won't be different.

Take the time now to figure out what a big loss would look like and how you would like to react. Write it down and store it somewhere easily accessible. If you never need it, you've done no harm to yourself. But I fear you will need it sooner rather than later-particularly if you have been telling yourself that all you care about is that the dividends keep getting paid.

Disclosure: I am/we are long PEP. 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.