All Dividend Stocks Have Their Limitations – Do You Know What They Are?
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Each and every one of the dividend stocks in your portfolio can reek havoc on your portfolio. The trick is figuring out what the limitations are and how to overcome them.
Three Limitations
1. All of a sudden they can stop paying dividends
Even a stock with an extremely long history of paying, and even increasing dividends, can one day run into extreme trouble and either stop the dividend growth or worse, stop the dividend payment all together.?
Take Bank of America (BAC) for example (I used to own it). Bank of America was a stock that was part of the Dividend Aristocrats and had paid dividends for a number of years. Look at the chart below from Dividend.com, which highlights one of the biggest risks of holding an individual dividend stock:
Click to Enlarge
2. Management can change and screw it all up
This really applies to all companies, but the performance of a company depends largely on the effectiveness of its management. A dividend paying company with a long history of solid performance can be brought down by one poor management team. Take
Home Depot for example.
Home Depot had been on a tear for years. The company doubled in size every 4 years from 1979 to 2001. Even though Robert Louis Nardelli did double sales from 2000 to 2005, his extraordinary pay package while they steadily lost market share to Lowe’s slowed growth and ultimately stalled shore price appreciate and dividend growth.
3. The dividend growth may not be enough to overcome a tanking share price
Dividend growth is often referred to as the holy grail of dividend investing. It is something that I seek out very actively – a large portion of a stock’s growth in value comes from dividends.
However, if that share price is going down drastically and actually stays down then that dividend growth may not matter too much. Sure you will get some of your money back through increasing dividends but it may not be enough.
How to Overcome the Limitations
I can offer up two suggestions for overcoming these limitations of dividend stocks.
1. Build a core portfolio of index funds that adequately diversifies you
Diversification is crucial. My approach to ensuring I am diversified is to hold a well balanced mix of index funds across a number of different asset classes. These low-cost funds provide the foundation for my portfolio.
With this base built up, I am able to diversify further into individual dividend growth stocks. I recognise that I am taking on more risk with individual dividend growth stocks, but this is somewhat balanced with that core portfolio of dividend stocks.
2. Hold enough stocks to be diversified
The second way to overcome these limitations is to hold enough dividend growth stocks to be further diversified. Like point #1, the game is to manage risk. The more dividend stocks you own, the more diversified you will be. However, you also need to be able to keep track of all of these stocks so it is best to be sure you have the time.
Make sure you are diversified across industries, sectors, and markets. The last thing you want is all bank stocks.
Summary
There are always limitations in each and every one of the stocks you hold, even the best dividend growth stocks you own. As an investor, be sure you recognise these limitations and use the above strategies to overcome them.
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9 Comments on this post
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The Rat said:
Nice thread. I think #2 is one that sticks with me the most. I have a similar investing approach as it relates to owing stocks that are offer solid dividend payouts and long-term capital appreciation. I agree in that a diversified portfolio of dividend paying stocks is key. Over time, my goal is to also increase the foreign content of my portfolio. The BAC example you mention further exemplifies the importance of diversification – if not it could be ‘diworsification!’
February 11th, 2010 at 11:22 am -
Brian said:
TDG: You’ve often pointed out the advantages of broad diversification using indexes. Can you write a post on dividend etfs which focus on dividend growth methodologies?
February 12th, 2010 at 10:06 am -
The Dividend Guy said:
Hi Brian – thanks for the comment. There are funds like that – and one company that comes to mind right away is WisdomTree. Their focus in on dividend yield.
I will queue up an article with that topic. Thank you for the suggestion.
February 12th, 2010 at 1:30 pm -
David said:
I owned B of A as well. I sold after the first dividend cut, but it still hurt. As for point #3, Pfizer (PFE) immediatley comes to mind in my portfolio. Another problem stock for me was Constellation Energy (CEG) which really tanked – I sold, luckily, before it hit bottom. Funny thing is, I ususally buy as if I plan to hold forever. I think I’ve learned to disregard a lot of analyst reports and dig, dig, dig for problems and potential downside before I buy. Totally agree on index funds (which I need more of), and diversifying with dividends growers.
The last year and a half has certainly been a learning experience.
February 16th, 2010 at 7:04 pm -
dean said:
The key to resolving this problem is being patient enough to buy the dividend stock when it is cheap. You mighthave to wait a year to buy your target stock. When the market crashes for some unexpected event, you jump in. Always keep some cash ready for big market drops!
December 6th, 2011 at 4:07 pm
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