Any idea taken to an extreme can bring dangerous consequences. Ideas can quickly become principles of conduct that govern our life choices. The blockbuster hit " Inception" from 2010 drives home that point. Mal, the wife of Leonardo DiCaprio's character, Dominic Cobb, was driven to suicide because she could not shake the idea that she was living in a dream, and the only way to wake up and return to reality with her children was to kill herself while in the dream.
While I am not suggesting that anyone is going to die from any investing ideas or principles, choosing to follow overly rigid ideas or principles could mean financial ruin at worst or underperformance at best.
As I have dedicated prodigious amounts of time to the study of securities markets, and especially as I have begun writing on SeekingAlpha, I have noticed certain ideas that have indeed taken root in many people's minds and have come to define their investment strategy. These ideas have achieved God status, commandment level, the violation of which is condemned. My intent today is to discuss why these principles, when taken to extremes, can have demonstrable negative consequences for investor portfolios.
A disclaimer that I need to get out of the way... I recognize that people have a variety of reasons for investing. People also have different investing goals. For some it is capital preservation. For some it is income. My comments today pertain mostly to those who are, well, seeking alpha. What I have to say is most applicable to those who are trying to beat the market as measured by the S&P 500. Nonetheless, it is my honest opinion that even for those with other goals, the things of which I will speak have application across the board.
The Golden Calf That Bellows, "Never Sell"
Occasionally in my articles, I have come under scrutiny for disclosing that I sold out of a position. Just recently in an article entitled "Great Company, Not Good Price: I Overpaid For A.O. Smith", a fantastic discussion was generated in the comment section that was pumped with insights from a variety of readers. Among those comments was one from BuyAndHold 2012 who stated, "One of the Ten Commandments of successful stock market investing is: Thou shalt never sell a Dividend Aristocrat." While I don't mean to show any disrespect, I will candidly disagree. In fact, I think there is considerable evidence to indicate that such a rigid philosophy puts capital at risk. This extends way beyond dividend aristocrats and in fact more fully applies to the rest of the world of publicly traded securities. Elsewhere on SeekingAlpha and in other investing communities, it is not uncommon to come across folks who say "I never sell at a loss". This "never sell" aspect deserves a lot of attention as there are considerable macro level and psychological problems with such an attitude.
Ergo, the Ego
On the psychological level, those who maintain a "never sell" mentality are simultaneously maintaining an unspoken "I am never wrong" mentality. It suggests a level of omniscience that no one can realistically attain to. Refusing to sell is the same as refusing to admit that there was any error in the due diligence process, that there was nothing unsavory about any given security that was left undiscovered. The "Never Sell" chorus, by implication, is surrounded by verses that say, "My knowledge is perfect regarding this publicly traded business; nothing can sway me from my position because I was never wrong in first taking it". It is an outright refusal to allow new factors to influence the investment thesis. "Never sell", of necessity, means never adapt, never be flexible, never cut your losses before they become more severe, never free up capital to be deployed into more profitable ventures, never admit that you may have made a mistake buying in the first place. Those who say "never sell" set themselves up as Gods whose opinion could not possibly be wrong. Okay.... enough with the strong statements. I get that things are more nuanced than this and that by and large it is wise to hold on to positions rather than jump in and out of them on a whim. But there are many who I feel are overly rigid in this regard. Sometimes, investors make mistakes. All investors. And those whose track records are the best are also those who know when to cut their losses, when to admit defeat, when to admit that they made a mistake or that something happened that changed their reason for investing in the first place. So they sell.
On a macro strategy level, never selling eliminates a full 33% of your options. After all, on any given day when markets are open we can choose to buy, sell, or do nothing. The "never sell" crowd can only buy or hold. They, of their own volition, have taken a tool out of the toolbox. Even tools that are only used seldom are important. Ever needed a flathead screwdriver but not had one?
When it has been determined that a mistake has been made, cutting losses is important. Vital even. In his book on Warren Buffett, Chairman and CEO of Berkshire Hathaway (BRK.A)(BRK.B), entitled "Buffett Beyond Value: Why Warren Buffett Looks To Growth and Management When Investing," Prem C. Jain explains:
One common (investing) bias.... is that of not selling a stock at a loss. But if you believe that the stock is overvalued, then you should sell even if the current price is below your cost and you have to take a loss. Professor Terrance Odean examined trading records for 10,000 accounts at a large discount brokerage house and found that investors are reluctant to realize their losses, which may be one reason for their underperformance relative to the market.
Along these lines, one of the most important principles I try to live by is "you don't have to earn it back the same way you lost it". This is logic in its finest form. Don't be married to any stock. Don't hold a loser stock, hoping to regain your losses, when you are missing out on better opportunities elsewhere. Whether you regain your losses in the first stock or sell it and regain that money elsewhere, the dollar amount will be the same. Never be afraid to sell at a loss if you know you made a mistake. Put that capital to better use (even if that better use is holding it in cash for a while). Be flexible. I have been guilty of holding on to a stock WAY too long that I never should have bought in the first place hoping to regain my losses and rationalizing that because it was a high yielder I should just wait it out. Foolishness. And I missed opportunities because of it.
Model the Pros
Perhaps the strongest point to be made in this regard is referencing the best investors in the world. If they aren't afraid to sell, neither should we be. Prem C. Jain also shared the example of Buffett's purchase of ConocoPhilips:
From 2006 to 2008, Berkshire invested more than $7 billion in ConocoPhillips (COP) stock when oil and gas prices were near their peak. The stock price subsequently dropped by 50 percent. In the 2009 annual meeting, Buffett mentioned that buying the ConocoPhillips stock was a major mistake.
Buffett went on to sell his position at a considerable loss in order to fund the purchase of more attractive opportunities. Let me repeat, for emphasis: Warren Buffett, perhaps the greatest investor that has ever lived, SOLD. So, how does that stack up against the very deliberate and oft repeated counsel Buffett has given to hold stocks for the long haul? After all, he has said on several occasions that his favorite holding period is forever. Well, I believe that people misinterpret and over-extend his advice. Just because his favorite holding period is forever doesn't mean his only holding period is forever.
P.S. COP has returned only 5.47% with dividends reinvested since 2006 when Buffett first started buying. You don't get or stay famous by holding onto positions that return ~5% annually.
There is an element of gambling to all common stock investing. No one can know everything there is to know about a company or the market and it's participants. Lessons from poker are therefore apt: know when to hold em', and when to fold em'.
It may not have been a mistake to buy, but it can be a mistake to not sell...
While sometimes a sell should be made because a stock never should have been bought in the first place, sometimes the reason for buying is right but later the investment thesis changes.
I bought American Outdoor Brands Company (AOBC) in early 2017. They had high return ratios, impressive revenue growth, margins were improving over time, and they were buying back shares. Everything pointed to a well run business. However, as I tracked inventory levels I noticed ballooning numbers. Supply was outstripping demand. They had ramped up production in anticipation of a Hillary Clinton, anti-gun, presidency, which stokes demand as people try to hoard weapons for fear of not being able to buy them at all in the future. When Donald Trump won the election, that demand never materialized. Furthermore, I noticed that AOBC was running tons of heavy promotional programs to unload all their inventory, which would eat away at margins. Storm clouds were clearly on the horizon. I sold out of my position over the course of a few weeks for a total return of 5.9%. Then the blood came....
There were other indicators that trouble was brewing. Poor quality earnings, silly allowances for doubtful accounts, inability to collect on receivables, a slew of questionable acquisitions.... the tea leaves weren't hard to read. It was a no brainer sell. In hind-sight, it was a no brainer short. I wish I would have had the guts to short it. But I avoided a 50% loss because I was flexible and didn't hold to any stodgy, ill informed "never sell" bias. I encourage you to peruse my series of articles on AOBC. It is a great case study in why you should never "set it and forget it" when it comes to common stock investments. No investment is ever so great that you shouldn't look under the hood at least once a quarter. Which is also why you should never hold too many stocks in your portfolio, otherwise you won't be able to keep up with the research. But that is a topic for another day....
Back to the aristocrats....
To get back to Buyandhold's specific comment and to test the durability of his "commandment", I compiled data that shows the returns of all 53 current dividend aristocrats from the year (in October) they became an aristocrat through this year (October), and compared each to the return of the market as measured by the S&P 500 over the same time period. For both aristocrats and the S&P, dividends were assumed to be reinvested. It is important to point out that the aristocrats have a built in advantage: their dividends constantly are rising whereas the dividends from the S&P dance around. In spite of said advantage, there were some real laggards:
|Ticker||Annualized Total Return||Vs. S&P||Aristocracy||Ticker||Total Return||Vs. SPY||Aristocracy|
*Here, here, and here are the calculators I used for the data. For some reason, the calculators I used did not allow me to enter certain years for certain stocks. It automatically bumped me up a year or two.
*All date before 1995 was measured through march of this year, because that is the latest the calculator allowed.
This table shows a couple vital truths:
1) Buyandhold 2012 is almost right. Most dividend aristocrats have beat the S&P, and the argument could therefore be made that you should never sell a dividend aristocrat (14 lagged the market, 39 beat). But therein lies the danger. Buying or owning a dividend aristocrat can provide a false sense of security. It can lead to sloppy due diligence or a refusal to revisit the investment thesis and look under the hood of a current holding. It can lead investors to think that because a fancy label like dividend aristocrat is slapped on a company, it is automatically worthy of holding forever. Just because something is almost always true does not make it worth the risk of investing like it is always true.
2) There are horrible laggards above. ExxonMobile (XOM). Chevron (CVX). Cardinal Health (CAH). Franklin Resources (BEN). AT&T (T) (who we will talk about later....). Even a 100 bps difference over many years turns into considerable underperformance in dollar amounts. Leggett & Platt (LEG) is a prime example: a 5.97% return vs. the S&P's 6.92% doesn't seem like that much of a gap. But if you had invested $10,000 in each in 1997, the year LEG became an aristocrat, your investment in the S&P would have earned you $7,059 more. And it's not like there weren't any signs that you should sell these companies. Without doing any deep due diligence, there are things right off the bat that you can learn in two minutes that deserve further research as they may indicate a struggling enterprise:
- XOM margins have been sliding for years.
- BEN has had poor revenue growth, flat free cash flow generation, all while working capital has exploded over the past decade. Who wants to invest in a company that is using more money to operate without translating that into more cash?
- CVX has huge CAPEX numbers, a necessity in their business but that has resulted in several years worth of negative free cash flow. From whence cometh that growing dividend?
Given all this, would you not have been better off selling, aristocrat status notwithstanding?
If "thou shalt never sell a dividend aristocrat", do you pound the pulpit harder when it comes to the dividend kings? Here is a similar table, with those kings not listed in the aristocrat list:
|Ticker||Annualized Total Return||Vs. S&P||Measured from||Ticker||Annualized Total Return||Vs. S&P||Measured from|
*All data for kings is through March 2018
So here we see the same. Most indeed outperform, or close to. However, Vectren (VVC) and Tootsie Roll (TR) severely lagged. Were there any indications that you should have dropped these for more lucrative opportunities? Sure:
Tootsie Roll - The lack of revenue growth over the last decade is indicative of the stagnant demand for the companies product, which consists mostly of old fashioned candies. TR appears to be struggling to keep up with changes in consumer taste. While I think they are a well run business that has managed to grow earnings in spite of no real revenue growth over time, well run businesses don't always make good investments.
Vectren - No revenue growth in a decade.
This point concerning aristocrats and kings is a perfect segue into my next topic.
Bowing Before Dividends
My opinion on dividends has shifted lately. The payment of a growing dividend has long been a critical component of my screens when searching for a new stock to buy. The payment of a dividend has HUGE psychological power. POOF!! money shows up in your account. Cash. You can do with it what you want. Buy a Big Mac. Buy McDonald's stock. DRIP. My thoughts have become more nuanced of late as I have read the opinion of others and thought critically. My new belief is this: a company should only pay a dividend if there are absolutely no better uses for that cash. Period. And the amount of that dividend should NEVER eat into money that can be used wisely elsewhere. Yet too many companies pay a dividend when there are clearly better uses for that capital. But to satiate their dividend hungry investors (who can be rather vocal, almost rabid sometimes...) and protect their own stock options, management and the board continues the dividend. If the only reason for paying a dividend is because the company has a long history of paying a dividend, that is an absolutely atrocious reason to pay a dividend. Worse yet, growing the dividend simply because there is a long history of growing a dividend is irresponsible and almost criminal in some cases as it destroys rather than unlocks shareholder value. Companies that engage in this behavior are literally saying "we are going to keep doing it this way because we have always done it this way". Such an attitude is stale, anti-innovative, inflexible, and by implication, anti-capitalist. Capitalism thrives on creative destruction, where old ways of doing things die because a better way has been discovered. For many companies, the dividend is paid in spite of better ways of using that money. With that, as promised above (and in anticipation of lively comments), lets talk about AT&T.
Before I get into it, let me say up front that my comments have little to do with Time Warner and whether or not anticipated synergies will be realized. It has nothing to do with content. Nor do I want to get into how "safe" the dividend is. I don't care how well the dividend is "covered". My point is to show that, whether or not they can afford it, the money being spent on the dividend could be better spent elsewhere. I disagree whole-heartedly with the capital allocation decisions being made by T management.
1) The parameters of the deal with Time Warner destroy shareholder value
A) The massive amount of debt T had to take out to pay for the deal increased the amount of debt per share that each shareholder holds. T took out about $40 billion in debt to finance the $85 billion acquisition. Total debt, as of the last quarter, stands at $168,495,000,000. This is mind boggling. Each shareholder holds $26.53 of debt. In a rising rate environment, the refinancing parameters of that debt are anything but attractive. Moody's estimates that T will have to refinance about $9 billion each year with an ever growing rate as the Fed continues to normalize the rate environment.
B) The part-equity financing of T reduces the stake each shareholder has in the company on a percentage basis and results in another mouth to feed with the dividend. T issued 1,125,517,510 shares in order to fund the equity portion of the buyout. At a dividend yield of about 6%, T will have to realize rates of return above that on those newly issued shares in order for the deal to be worth it as they pay out that money in dividends. If shares outstanding stay at current levels AND they continue to grow the dividend, that hurdle rate gets higher. Perpetually. As long as that dividend keeps growing. Objectively, shareholder value has been diluted at least in the short term and perhaps permanently if TimeWarner synergies aren't realized.
So not only are they paying handsome sums of money in interest on the newly issued debt that will take a long time to repay, sums that will only get higher on a percentage basis as debt is refinanced, but they are also spending several billions a year in dividends on newly issued shares. That number will only get higher as they continue on their hell-bent dividend growth path (all the hail the aristocrat status). How can this deal possibly be "accretive"? It is a gamble. There is ample evidence in studies that we have all heard about that show that mergers and acquisitions rarely result in value creation. Expected synergies are usually NOT realized. So T pays massive amounts of money for a deal that might not work?
T is on track to pay $12 billion in dividends this year. IF the TimeWarner deal was really THAT attractive to warrant a 35% premium, why not suspend the dividend to help finance the transaction? $36,599,000,000 was paid in the form of equity. T's share price was anything but elevated at those levels, so to use equity as currency was foolish. Again, IF TimeWarner was a MUST BUY NOW, why not just pay for it all in debt, suspend the dividend, and use cash from operations until debt comes down to MUCH safer levels? It would only take a year or two. I can already hear the people shouting "stone him!" for suggesting a dividend suspension. But it makes sense. The problem is that investors, management, and boards get tunnel vision. Too many worship the dividend god, and deliberately choose to not realize the MANY other ways that shareholders can be rewarded. Shareholder value is unlocked in a multiplicity of ways to include dividends, investing in core operations, stock buybacks, accretive acquisitions, AND PAYING DOWN DEBT. That's right. Getting rid of debt unlocks shareholder value as it makes everything safer. It frees up cash. It improves credit ratings. Low debt is a huge component of financial flexibility. But the only thing people seem to care about is the dividend.
2) After inflation and taxes, is the dividend really worth it?
One objection I anticipate hearing is "but what about all the people/retirees that want/depend on the dividend for income?" Without being able to accurately measure the claim, I daresay that the percentage of T shareholders to total shareholders who rely on the dividend to live off of in retirement is rather slim. I really don't think that there are that many. Even then, the value that would have been unlocked from allocating capital in wiser ways than insisting on a growing dividend would have, in my opinion, more than made up for the couple bucks per share that retirees would have missed out on from a brief dividend suspension. Furthermore, taxes will bite that dividend, HARD, retiree or not. T pays a dividend of $2.00 per year. If you are married, filing jointly, with an $80,000 a year income, that $2.00 will be hit 15% by uncle Sam for shares held outside tax protected accounts, which it must be if people are wanting that money for current income. So that $2.00 actually is only going to make you $1.70. Trading at around $32.50, that yield is now only 5% instead of 6%. The other matter to take into account is inflation: how that will affect cash dividends paid and how that will affect any dividend growth. So why not want and indeed demand that boards and managements take measures that reward shareholders just as directly (though perhaps not as tangibly as cash) and in a tax free way? In other words, pay down debt. Make acquisitions without using equity. In the future, use the newfound financial flexibility to retire stock which will further free up resources and increase percentage ownership.
3) Why not invest in the core business?
Customer service and cellular network coverage represent critical components of AT&T's CORE business. Wise dollars could be spent in these regards that would lead to better customer retention. Why throw good money after new, questionable ventures, when there is plenty to be done to invest in core operations? Train your employees to be better at their job and offer warmer customer service. Update your coverage to have better service in places that are consistent dark spots. Instead, a hefty premium was paid for entertainment assets, the return on which can't be known until after the fact. We just have to take managements word for it that it will provide synergies. If there are two words that give me jitters, they are "synergies" and "accretive acquisition".
Concerning dividends and with a particular application to aristocrats and kings, Prem C. Jain said:
A regular dividend payment by itself is not a strong enough variable to characterize a company as a good investment. When a company paying regular dividends also raises funds in the financial markets and the balance sheet is not strong, you should be careful about investing in its stock. Dividend payment is just one possible use of free cash flows. What is most important is your comfort level with a company's usage of its free cash flows. Companies have many choices other than paying dividends: They can undertake new projects, repurchase their own shares, and invest in financial assets. If you are not comfortable with management decisions on its usage of cash flows, especially its investment policy, you should not buy the stock in the first place.
Final Dividend Thoughts
To conclude this section, I wanted to share some more quotes from Prem C. Jain, who I mentioned before, and another SA user who I respect, KMR holder. This individual has commented on several of my articles and I find what they have to say well thought out and reasonable. Their words have really influenced my opinion and for that, I am grateful:
I'll leave you with this regarding corporate uses of capital.
Invest in the business if appropriate.
Pay down debt if unreasonable.
Buy back stock if extremely under priced.
Pay a dividend to shareholders, preferably a special dividend, since a regular one leads to the wrong kind of shareholders.
A regular dividend is like a tax on the business's potential to grow. It leads to shareholders who have not as much faith in the business. If they had enough faith, they wouldn't sell in droves like many would if the dividend isn't maintained.
Paying a regular dividend is a self imposed tax on the business bottom line.
People don't look at dividends properly in my opinion. They see the cash coming to them in the present and ignore what could come to them if the management is able to productively put it to work within the company.
A company that regularly pays out increasing amounts of money to its shareholders are to some extent bribing its shareholders to buy the stock with the inducement of the dividend stream. What is the result of that bribe? Investors are more likely to buy and hold. They are less likely to hold management responsible for making good management decisions including capital allocation.
I doubt that the board of directors sit down each quarter and discuss if it makes better sense to pay their regular dividend or even increase it or if they should buy XYZ instead, or pay down more of the their revolver or other debt. I truly doubt if they discuss whether they should increase marketing or improve their production facilities rather than increase the dividend.
Paying a dividend does not effect future cash flow of a business positively to any degree! The larger the dividend a company pays, the less cash it has to invest in the business. If the dividend reduces the money a business can profitably put to work in the business it can reduce future cash flow growth.
From Prem C. Jain
The practice of paying regular dividends is a long-standing puzzle. In a well-known article, two Nobel laureates in economics, Franco Modigliani and Merton Miller, wrote that a company's value does not depend on its dividend policy; rather, value depends on how the company invests its resources. After all, dividends are equivalent to transferring shareholders' money from their accounts with the company to their personal accounts. When a company pays a dividend, its share price drops by almost the same amount as the dividend.
In most cases, companies pay regular dividends simply because it has been a long-standing corporate practice. There are no strong reasons to support paying regular dividends, however, especially when the balance sheet is not strong. Instead of focusing on the dividend policy, you should spend more time analyzing the sources and uses of a company's cash flows, which ultimately determine the stock price.
Fischer Black (university professor, Goldman Sach's partner, and co-author of the Black-Scholes equation), argued that because of the U.S. double-taxation structure where corporations first pay taxes on earnings and then individuals again pay taxes on dividends, both corporations and individuals should prefer no dividends. Corporations should only return earnings to their shareholders as cash dividends when they do not have projects with reasonable rates of return and their own share prices are high. If the share price is low, they should repurchase their own shares.
One final anecdote about Warren Buffett that puts together both my points today. Buffett began buying shares of DirectTV in 2011. Ultimately, AT&T bought DirectTV in 2016 (at a 30% premium before rumblings of the deal began circulating) using debt and stock, resulting in Buffett receiving AT&T shares. After the deal closed, Buffett wasted no time in unloading AT&T. In just two quarters he liquidated his position. While investors have a huge number of reasons for selling stock on any given day, it is safe to assume that Warren Buffett sells for only one reason: he does not believe that position will result in high rates of return in the future relative to other investments. I am willing to bet that part of Buffett's antithesis to owning AT&T was their capital allocation practices. And in summation, Berkshire Hathaway does not pay a dividend. Buffett is perhaps that best capital allocator in the world. His lack of a dividend payment speaks volumes about what he feels the role of a dividend is. I am sure he doesn't hate dividends. He owns tons of companies that pay dividends. But he knows that there are better uses of capital and those should take priority so long as they are available.
In all my talk about not being afraid to sell, I feel it necessary to mention another rule that some people have as part of there investment strategy that I consider to be extremely short-sighted. There are those who sell a stock if the dividend is cut. No questions asked and immediately. I believe that this is incredibly hasty, as sometimes companies have remarkably good reasons to reduce the dividend. In other words, they found better places to put that capital. While further research would be warranted to see if the cut dividend is a result of an irreversible and severe deterioration of business fundamentals, selling before doing that research is not good investing. It is reactionary. So while I of course believe that no one should have a rule against selling, I also think you should have darn good reasons for selling. And a cut dividend isn't necessarily a good reason to sell.
As you survey your motives and goals as an investor, candidly look at your perspectives and see who or what your gods are, and honestly ask yourself if the deference and worship you give them is warranted and lucrative. Don't be scared to sell, and have a wider view of capital allocation than "do they pay a dividend?"
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.