Would You Accept A 50% Loss?

Value investors are constantly on the hunt for companies that are trading at valuations below what they are actually worth.  Dividend investors often look for similar discounts while searching for a steady stream of income.  Successful dividend investors are the ones who repeatedly find companies that pay increasing dividends and purchase them at a discount to their fair value.  This approach boosts not just the passive income stream but total returns as well.

Since dividend investing is by design a long-term strategy dividend investors tend to be less sensitive, almost to a fault, of price fluctuations in their holdings when compared to more short-term oriented investors.  Small fluctuations are of little concern and can mostly be covered by that year's dividend.  It may not be exciting to break even on the year but it is preferable to a loss.

Larger declines in price though can get dividend investors in trouble.  Let's assume that the holding in question has not acted in a way to provoke a typical red-flag (as in a dividend freeze, cut, or elimination).  Perhaps it missed earnings or had a shake-up in its senior leadership.  As an individual investor it is on you to use the resources available to you to determine whether such events invalidate your original investment thesis.  However after making the call to hold on to the stock (or perhaps buy more) how would you react to your position getting cut in half within the year?

Don't make a kneejerk response.  For some stocks a 50% decline puts them in "screaming buy" territory (think Coca-Cola in March of 2009).  For others it is a sign that the market doesn't have faith in the company's prospects and that your cash is best invested elsewhere.  Again that is going to have to be an evaluation that you make on a case-by-case basis.  However now that the stock has declined well below a level where the dividend yield could provide you a short-term buffer you need to start thinking in terms of opportunity cost.

Time to go hypothetical: you invest $1,000 in ABC company which has a yield of 4% and somehow manages to increase its stock price at a reliable 6% per year.   Unfortunately the day after you buy the stock a competitor comes out with a better product and the stock starts a 3-month decline that cuts the stock price in half.

But at least you collected that 4% yield.

If we assume the company's stock price is going to continue to appreciate at 6% per year while the annual yield remains at 4% (its so much simpler to do things hypothetically) you stand to get back to even in seven years.  After that you can start making a profit off of your investment.  Talk about delayed gratification.

Consider the likelihood of you taking what was left of your investment after that first year and doubling it in seven years.  You'd have to earn a little over a 10% annual return in order to be able to do so which requires a bit more than beginner's luck but is not unattainable.  Just a couple of solid selections can get you back to even in much less than seven years.

Think 10% is to hard for you to attain?  Think given this situation you would rather take the slowly recovering stock?  Fine but now forget the hypothetical and embrace reality: how many companies that take 50% hits due to a serious change in the business environment can maintain a 4% dividend yield when faced with declining cash flow?  Not to mention that a 6% annual return on the stock price alone in this scenario is unlikely as well.  That means that the time required to recoup your investment will stretch well beyond the aforementioned seven years.

And that means you need to look for a better place to put your money.

Related Post: Opportunity Cost: Or Why I Should Have Sold Ford
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