MAKE MONEY IN ANY MARKET
Editor's note: An earlier version of this article stated that the share price of Cablevision Systems declined sharply over the past year. Cablevision paid a special $10 dividend in April 2006, which was not accounted for. We regret the error.
If you've been paying any attention to the stock market recently, the term "roller coaster" probably comes to mind. The frantic up and down motion of the market provides thrills, spills, and the occasional upset stomach. Unfortunately, the downward plunges in your investment portfolio aren't nearly as much fun as the exhilarating drops on a real roller coaster.
As an investor, those wild swings present a dilemma. You have to be invested to take advantage of the long-term, generally upward movement in the market. Yet money in stocks is at risk, and there's nothing really protecting you from the inevitable slides. And stock drops can happen to any business, not just the tiny firms where extreme volatility is expected. Just look how far even some big companies have fallen in the past year:
Because of that tremendous potential for loss, a good rule to follow is don't invest money you'll need in the next few years in stocks. But if you're like most of us, it's a challenge to save enough to invest at all, much less enough to have a targeted plan with specific, appropriate assets earmarked for each goal.
Cheat the systemRelying on generating enough cash from selling your stocks to cover your needs is a dangerous game to play. After all, when push comes to shove, you could get caught short if you're forced to sell when your stocks are down. There is, however, a way to get cash from your stocks without the risk of having to sell in a down market. That is, you can have your cake and eat it too. If you buy stocks with solid, sustainable, and rising dividends, you can take advantage of the long-term appreciation of stocks, while receiving cash to do with as you please. That is the fundamental premise behind Foolish colleague Mathew Emmert's investment philosophy for Motley Fool Income Investor.
Sure, dividends are not guaranteed payments. But even without a guarantee, companies that pay regular dividends will rarely cut them unless their situation becomes dire. That's because corporate boards know that dividends send strong signals about the true strength of the company. Precisely because dividends are neither guaranteed nor required, a rational company won't initiate one until it believes it has the financial strength to maintain it.
Why dividends ruleThat seemingly simple act of authorizing a few cents distributed to the holder of each share hides a very complicated calculation. Unlike bonds or preferred shares, which are little more than tools for raising money, common shares actually represent an ownership stake in a business. The owners are last in line for any money the business generates. After all, the employees must be paid, the tax collector requires his share, the company's suppliers won't deliver for free, and the bondholders and preferred stock holders take priority over the owners.
It's largely because of the tremendous hurdles that a company must clear in order to be able to pay dividends that the signals they send are so strong. A company that declares a dividend essentially announces to the world that it has reached the ranks of the financially mature. It's quite an embarrassment, and one that often comes with a stock price drop, to later admit otherwise with a dividend cut.
Take, for instance, struggling automobile titan General Motors. The company faced the following financial crises before finally cutting its dividend:
Negative operating cash flow in 2003
Money-losing automobile operations in 2004
A $10.6 billion net loss in 2005
Yet the company didn't cut its dividend until its first 2006 payment. That's at least three years of struggling operations and clear clues that the dividend could be in serious jeopardy before the company finally admitted that it needed to cut its payment to conserve cash.
Finding the right signalsIf companies will go to great lengths to protect their dividends, then the smart ones will do their best to set those reasonable payments. By reasonable, I mean the dividends are:
Easily covered by the company's operating cash flow
Increased in line with the company's long-term growth
Low enough to allow the business to reinvest in sustaining and growing itself
Timed such that the company's cash on hand can make the payment
That timing requirement may seem strange, but consider the case of toy maker Mattel (NYSE: MAT). In 2002, it made the decision to pay its dividend in one lump sum every year -- in December. That makes significant strategic sense. After all, its business is heavily weighted to the end of the year, thanks to the preponderance of toy-friendly holidays. It simply makes sense to pay its owners when it has lots of cash coming in, rather than trying to come up with excess cash every quarter, including those that simply aren't usually that profitable.
Your edgeBy investing in companies that pay sustainable dividends, then watching for signs that they're faltering, you can put yourself in the enviable situation of making money in any market. Take, for instance, Income Investor selection Dow Chemical (NYSE: DOW). While its shares are down a bit since being selected for the newsletter in March 2004, it has continued to pay its dividend. In fact, earlier this year, it actually hiked its payment about 12%.
Investors who bought the stock for its stable, reliable dividend have been rewarded not only with the regular cash flow, but with a raise, too. That's what you get when you follow the Income Investor strategy. You sit back and rake in the cash, no matter which way the stock market happens to be moving.