Dividends, Short-Term Pain, but Long-Term Gain?

Key Points

• Not all dividend stocks recover or even stay in business.
• Dividend stocks drop by the amount of the upcoming dividend on ex-dividend dates.
• Dividend stocks tend to recover their dividend drops over time in bull markets but can be a double whammy in bear markets.
• Researching and rotating your dividend stocks are vital factors.

Dividend stocks drop by the dividend amount on the ex-dividend date. The stock takes a short-term hit, but the shareholders are compensated in cash on the payout date. If it's a wash, why are there so many dividend investors? Simple. Dividend investors seek income from holding their stocks long-term. They don't feel they lose anything because they are getting paid the dividend, and the short-term price drop will eventually be recovered if they hold the stock long enough. Well, that may only sometimes be the case.

Benchmark Indexes Rise But Stocks May Not

The stock market has historically risen in the long term. That statement is true, depending on where you got in. Long-term investments in the stock market appreciate in time if you invest in the benchmark indexes. This only sometimes applies when investing in single stocks. The S&P 500 and the Dow Jones Industrial Average (DJIA) continue to climb because they actively add and remove components. When a stock underperforms, it gets kicked out and replaced by a performing stock.

And Then There Was One.. Kind of

Every original company on the Dow Jones Industrial Index has gone bankrupt, restructured, gone out of business, or merged except for General Electric Co. NYSE: GE, which was actually kicked out but added back in. However, they dropped again in 2018 after GE stock fell (55%) and cut its dividend. It was replaced by Walgreen Boots Alliance Inc. NYSE: WBA. General Electric has since executed a reverse split and announced plans to split it into three standalone companies.

Broke, Restructured, or Merged

Countless former household names have gone the same way RCA, Sears, Kodak, Bethlehem Steel, and even General Motors. While General Motors seems stable now, it filed for bankruptcy in 2009, and the shareholders got smoked when they canceled the common shares, which became worthless. General Motors emerged from bankruptcy after restricting and issuing new shares.

Stock Selection is Critical

Monitoring your dividend stocks for underperformance is essential as benchmark indexes swap out underperforming stocks. There are two reasons for the underperformance, macro and/or micro. Stocks move with the overall market. If the benchmark indexes fall, most stocks will do the same regardless of fundamentals. However, if a stock falls due to specific material developments and weaknesses, it should be replaced or trimmed down.

Fundamental problems like declining growth, growing losses, shrinking margins, outdated products or services, vanishing end-user demand, and irrelevant legacy products or services are all catalysts for disaster. Accounting irregularities, fraud allegations, SEC investigations, and criminal charges are more signs of bad news. If your dividend stock has any of these maladies, it's time to reevaluate the investment. Remember that a 10% dividend seems like it could be better if your stock has fallen (60%).

Market Climate is Important

Dividend stocks are great in a rising bull market. Bull markets enable capital appreciation from rising stock prices and income from dividend payments. Stocks tend to recover the dividend gaps quicker. However, bear markets can be doubly painful. Dividend investors suffer from falling stock prices on top of the dividend gaps down. In these situations, it helps to diversify across different sectors and industries.

Use tools like the MarketBeat Dividend Screener always to have a few dividend stock candidates available in case you need to swap out. For the nimble, a dividend capture or covered call strategy on dividend stocks can help buffer some downsides. However, making an honest, objective assessment is critical to determine if holding the stock for the dividend is worth when the business has gone south with the stock price.

Don’t Be Chained to Your Dividend Stock

Dividend investors can often delude themselves into holding dividend stocks down. The writing may be on the way as the company continues to miss earnings estimates and lower guidance. Yet, many dividend investors feel obligated to hold the stock "long-term" and focus solely on the dividend check every quarter. This happens until one day, the company announces a dividend cut or, even worse, eliminates the dividend since it needs the cash for operations or debt financing. These are not just imaginary situations but cautionary tales.

Don’t let this be you. Technology, cultures, and lifestyles change, so should your investment portfolio change over time. If investing in dividend stocks, continue to research them and rotate them out or buy an index fund.