Now that I’ve traded the chains of employment for the wide-open vistas of Financial Independence, there are very few things I miss from my working career.
But along with the job, came steady pay increases. Most of the time these were really minimal — mere 3% cost-of-living increases.
So why do I miss those tiny raises? The need for a constantly growing income is a real concern when you no longer rely on a job — inflation constantly eats away at the buying power of a dollar. Given enough time, inflation can cause serious damage to a long-term investor.
This is why I love my dividend growth investments. Every year these guys “raise” the dividend payout above the rate of inflation, which provides for a growing income stream.
Except sometimes they don’t.
Recently I’ve had a few of my investments “skip” their standard raises. They’ve been merely maintaining the current payout.
It’s got me thinking — What if my investments fail to increase dividends above the rate of inflation? Should I sell those investments, or hold-on in the hope of future increases? Would it be worth it to suffer through capital gains taxes in order to change investments and realize income growth again?
These questions aren’t easy to answer, but I did have some thoughts on the subject I’d like to share today.
Like a good slap-in-the-face, recessions are great at bringing even the most wild-eyed investors to back to reality. Recessions remind investors that stocks don’t always go up, and dividends don’t always rise.
While many companies struggle during recessions, there are always few companies that continue raising dividends — I wrote about them recently in the post “Have You Met The Dividend Achievers?”. Those guys are rare birds.
In many cases, dividend increases are postponed during recessions until better days return. In bad recessions, dividends can even be cut to preserve cash for the survival of the company.
So, this brings us to the question — During a recession should I sell an investment that halted dividend increases? Or cut dividends entirely?
In most cases I wouldn’t. The recession usually isn’t the fault of the companies that halt dividend increases, and preserving cash during such times can actually be a very smart move by the business managers.
In many situations, doing the exact opposite (buying more) is the smarter move during a recession. Assuming the company eventually survives and returns to a healthy state, buying investments during a recession means higher long-term returns and the potential for much larger dividends in the future… exactly what investors want.
During the 2009 Great Recession, Wells Fargo (a perennial dividend grower) was cutting dividends significantly. Dividends dropped from $0.34 per share to $0.5 per share. During the same time period, the S&P 500 cut dividends by 23%. Other large banks like Chase and Bank of America did the same. Nobody was immune from the effects of the recession, not even index investors.
It wasn’t until 2014 that Wells Fargo exceeded it’s old $0.34 payout, and 2013 for the S&P500.
Four to five years is a very long time to wait for a dividend increase. But, it was also the right time to buy more stock. Shares of Wells Fargo and the S&P 500 have more than doubled from where they were in 2009, and dividends are higher than ever.
History will show the recession as a blip for Wells Fargo, but for competitors Wachovia and Washington Mutual, the recession proved fatal. If you recall, Wachovia was purchased by Wells Fargo at bottom-of-the-barrel prices, and Washington Mutual went completely bankrupt.
This little history lesson provides an interesting maxim about investing during recessions — it’s not the income that matters, it’s picking the survivors.
Declining Financial Conditions
Recessions aren’t the only reason why dividends can be cut. Companies can run into financial trouble from poor management and/or declining industry conditions.
Such financial pressure can eventually lead to halted dividend increases or even dividend cuts.
Unless you live been living under a rock, you’ve probably read about or experienced how oil prices have cratered in recent years. Gasoline is dirt cheap, and airlines are actually making money. While that’s great for airlines, the oil industry has really been feeling the pain!
This pain has translated into minimal dividend growth for stocks in the oil industry — In 2016 Chevron only raised dividends by a single penny, and Exxon only raised by two pennies — really just token increases that tell investors “Yes, we know the dividend raises are important”.
Other companies like Kinder Morgan even cut dividends by 75%! KMI’s stock price cratered as a result.
More than likely, all three of these companies are going to survive these difficult times. All three are strong companies, but I really like how Kinder Morgan’s management dealt with the problem.
Why? The pressure to maintain dividends at Exxon and Chevron will eventually cause declining financial conditions. All three companies are paying dividends that exceed their earnings — a payout ratio well over 100%.
While Exxon and Chevron were able to maintain their previous payout rates, they’re actually driving themselves into a bit of a hole financially.
Debt levels and payout ratios at Chevron and Exxon are getting worse, but they’re actually improving over at Kinder Morgan.
Given enough time and excessive dividends, Exxon and Chevron could drive themselves into very poor financial shape.
When you think about it, this is situation is very similar to a person who suddenly loses a job. That person can maintain their standard of living using credit cards and debt, OR they can avoid further financial ruin by cutting back their spending.
That’s exactly what’s going on here. Kinder Morgan is cutting back, while Chevron and Exxon are still living “high-on-the-hog”.
The big lesson here is that investors shouldn’t hold dividends as “holy”. If business conditions decline, the right move is to preserve the financial health of the company… even if that means crazy-big dividend cuts. Short-term pain, long-term gain.
Ultimately business blips are going to happen in most industries, so the diversification of income streams is important for investors who live off dividends like myself.
Always be prepared to cut back your spending and invest more when prices are low… especially when management acts responsibly.
Maybe you’ve finally had it though. Maybe you want to call it quits on that international index fund, or that hot stock you invested in — You’ve put up with no dividend raises, and poor returns for years. Despite some capital gains in past years, you’re feeling the itch to sell.
But is it worth it if you have large capital gains you’d realize from such a sale?
In most situations, I think it’s probably worth it to pay the capital gains. Unless brighter days are already on the horizon, a turnaround might never happen.
While I love long term investing and the returns it can provide, certain sectors of the investing world can remain depressed for decades. As Warren Buffett is famous for saying, “Turnarounds seldom turn”.
Hypothetically, let’s say you sell and pay your taxes. In most cases that means you’re looking at 15-20% less capital to invest (depending upon your tax bracket). At normal rates of stock returns, this means recovering from that setback is only two to three years away. Not that terrible.
Overall, I believe it’s better to keep your dollars invested in industries that see good returns on capital rather than struggling with duds. Eventually if you’re invested in the right funds (or the right stocks) you will see income growth again.
While I do love a growing income stream, if anything these examples emphasize a major point — The dividend tail should not wag the investing dog.
In other words, dividends alone should not drive investing decisions.
It’s often the case that investors who depend on dividend income for living expenses tend to overemphasize dividends as part of their investing criteria. I believe this to be a wrongheaded way to invest.
Dividend cuts and raises are merely a symptom of change within a business or industry — it could be either good or bad. Without further research, an investor will never know whether it’s the right move to buy or sell.
Do your homework folks.