There are risks to many strategies. Some risks include permanent impairment of capital, due to an investment that ends up going to zero. Some companies would usually cut or eliminate dividends a long time prior to going under. This usually serves as a last warning sign to long-term investors like myself that something is broken in the business. But dividend cuts are not the biggest risk to dividend growth investing. This is not the risk I will discuss today.
The other risk includes mistakes of omission, where you fail to pull the trigger on a company because of fear. Then another risk is that you have identified an asset that has potential, purchased it at the right price, and it ends up meeting or exceeding your projections. However, you are not around to enjoy the full benefits of your analysis. While many cite dividend cuts as one of the biggest risks behind dividend growth investing, I believe that getting my shares acquired to be a much larger long-term risk to investment returns.
One way this could happen is if you sell a perfectly fine company. Some end up selling due to fear of the unknown. Ironically, share prices fluctuate much more than the changes in underlying fundamentals. This is why I try to focus mostly on companies that have stable earnings streams. A cyclical company with more volatile earnings streams is much tougher to value, and therefore I might be expected to receive more price volatility for each dollar of potential earnings power ( which in itself is a moving target). If you are good at timing your purchases, you may make a lot of money. If you are like almost everyone else however, chances are that exposure to cyclicals is best to be taken in a way that encourages doing nothing.
The other reason you may end up disposing of your shares is when your company gets bought out by another company. Investors usually show excitement when their shares are acquired, because the shares are acquired at a premium to the price immediately preceding the announcement.
The problem here is that a buyer will likely rob you from future improvements in the business. This means that you will have to realize all those capital gains when you sell ( assuming that you receive some cash and not stock in the new company).
In many cases, the shareholder might have been better off simply holding on to the company as a standalone business. If a smaller company is acquired by a competitor, its risk and return profile shifts dramatically.
The other issue with acquisitions occurs if you bought too high, and the buyout occurs at a price that is lower than your purchase price. This risk is one of the reasons why I try to avoid overpaying as much as I can. I do not want to overpay for a growth business, which goes through some temporary problems that reduce the P/E multiple, and is ultimately acquired at a price that is at or below my cost. To add insult to injury, I am missing out on all future growth in earnings and dividends, and now have to find another quality company for the long-term portfolio I manage. Unfortunately, the number of quality companies is limited. The availability of quality companies selling at an attractive enough entry price is even scarcer.
The whole philosophy behind dividend growth investing is that I will invest in quality companies with a track record of raising dividends annually, which I expect to further growth earnings,
dividends and intrinsic values over time. If I cannot take full advantage of the expected long-term growth in dividends and share prices, then it makes no sense to risk my capital – it might be better served elsewhere. Of course, since I never got that crystal ball from Amazon, I will keep getting bought out.
I received the idea behind this article, after reviewing the old stock manuals. Back in 1980, McCormick was almost acquired. Lucky for shareholders, it wasn’t. McCormick (MKC) sold at a split-adjusted $1.16/share at the end of 1980. The stock has paid a growing amount of dividends for the subsequent 36 years. Today, that stock price is $100/share and each share rewards its rightful owner with a cool dividend of $1.88/share. This represents an astronomical yield on cost for that lucky investor who took a chance on the company at the end of 1980. If the company has been acquired instead, all that wealth would have been enjoyed by the acquirer.
I know this is an extreme example, but a $10,000 investment in McCormick (MKC) at the end of 1980, with reinvested dividends, would have turned into $1.75 million by May 2017. If the company had been acquired for double the $10,000 initial investment, shareholders would have been robbed out of over $1.7 million worth of future wealth. Using the Pareto Principle Of Dividend Investing, if you do not hold on to the few companies that do most of the heavy lifting for you, your future results may suffer greatly.
GEICO was another dividend growth company that was unfortunately acquired by Warren Buffett in 1996 for $70/share in cash. Shareholders ended up paying capital gains, which reduced the amount they had to invest. If they had received shares in Berkshire Hathaway however, they would have done much better. Buffett shrewdly paid $2.3 billion in cash for the 49% stake in GEICO which Berkshire Hathaway didn’t own in 1996. This valued the whole GEICO company at roughly $4.60 billion in 1996. The company has increased insurance float to $17 billion in 2016, and has consistently earned an underwriting profit since the acquisition. Shareholders have missed out on all underwriting profits and investment income from GEICO for the past 20 years. Buffett has been singing praises of GEICO in almost every Berkshire Hathaway annual report. This is from the 2016 Berkshire Hathaway letter to shareholders:
“GEICO’s low costs create a moat – an enduring one – that competitors are unable to cross. As a result,the company gobbles up market share year after year, ending 2016 with about 12% of industry volume. That’s up from 2.5% in 1995, the year Berkshire acquired control of GEICO.”
After writing this post, I read that Brown-Forman (BF.B) had rejected a bid from Constellation Brands (STZ). I was glad that this company rejected the offer. This is because I believe Brown-Forman to be a quality dividend growth company that will likely be worth more in 10 – 20 – 30 years, and will shower its shareholders with a higher dividend during that time.
Just for the reference, I have had the following dividend cuts at the time of ownership since I started in 2008:
American Capital Strategies (ACAS) was a high yielding business development company that I purchased in 2008. I promptly sold it several months later, after the BDC suspended distributions.
State Street (STT) was another victim of the financial crisis. The company had raised dividends twice per year for 27 years in a row. Unfortunately, it cut dividends in early 2009.
General Electric (GE) was the posted child of terrible capital allocation. The company cut dividends