You Are About to Lose a Fortune

I've noticed a disturbing trend. More executives are being forced to sell because of margin calls. Recent victims include insiders at Boston Scientific (NYSE: BSX  ) and Chesapeake Energy (NYSE: CHK  ) . Chesapeake CEO Aubrey McClendon forfeited virtually his entire stake in the company he co-founded 20 years ago.

A more than marginally bad idea
Margin is debt. When you buy on margin, you're borrowing from your broker to buy more shares than the cash in your account would normally allow. It's a secured loan, insured by the value of your portfolio's holdings.

As you might expect, margin is often popular during bull markets, because of how it can multiply returns. You pocket the difference between what you pay in interest and what you earn in gains, and it feels like free money.

The trouble starts when stocks fall. Brokers require a minimum amount of equity for each dollar of borrowing -- often as much as 50%. Lose equity via a depressed share price, and you'll be exposed to a margin call. At that point, your choices are to (a) add cash to your account or (b) sell shares to raise capital.

Insiders who borrow to buy, and are then forced to sell, create a particularly vexing problem. High-volume insider selling tends to breed institutional selling (i.e., hedge and mutual funds), which depresses prices and, in turn, creates more margin selling.

Not to mention non-margin selling. History shows that investors often panic when selling starts. Already, we've seen two panics in the past year. The more leverage out there, the more likely that we'll see yet another panic -- one that might push the Dow down closer to 5,000.

A strategy for the worst of times
Writing that almost puts me into a full-blown, thumb-sucking, fetal-position panic. But I'm soothed by the monster month that March has been. The S&P 500 is still off some 10% in 2009, but it was down twice that at the end of February.

Losses could revisit us at any moment. Mr. Market is like that. Can there be any hope for long-term investors? Or have we all been banished to Shortville, where every sentence ends with "booyah," every dinner is ice cream and gumballs, and every stock is so toxic that short-selling feels like a sure path to fabulous wealth?

I think there's hope for us long-termers. Look at the evidence. Even if it seems like every stock is toxic, some have been outstanding. Stocks that produced free cash flow, maintained sturdy balance sheets, and paid dividends did particularly well during 2008.

McDonald's (NYSE: MCD  ) , for example, was a rare stock market winner in 2008. The burger baron is what researcher Mergent calls a "Dividend Achiever" for its history of paying ever-higher dividends over the course of decades, even in the face of earlier recessions. Other notable dividend winners from last year include Quality Systems (Nasdaq: QSII  ) and Wal-Mart (NYSE: WMT  ) .

Looking back over a longer period -- 1970 to 2000 -- Professors Kathleen Fuller and Michael Goldstein found that dividend-paying stocks outperformed non-dividend-paying stocks during market declines by an average of 1% to 1.5% per month.

But while dividends are important, they aren't a magical elixir. Last year, many notable dividend payers crashed and burned. (Lehman Brothers and Bear Stearns both paid dividends.) Your focus, then, shouldn't just be on the payouts themselves, but on the payouts in combination with strong free cash flow generation and sturdy balance sheets.

Is the worst yet to come?
The market has been rocky for nearly 18 months now. Redemption calls have forced hedge funds and mutual funds into selling. And as I mentioned at the outset, too many executives -- like the insiders at Regions Financial (NYSE: RF  ) and Green Mountain Coffee Roasters (Nasdaq: GMCR  ) -- have bet on margin. In other words, stocks will remain volatile.

That's why dividends -- with their predictable quarterly cash payouts -- make so much sense right now. While dividends can juice returns, of course, they don't exempt you from the short-term craziness in the market, where hedge fund selling can send stocks down, or where a CEO's margin bet can go stupidly wrong. But dividend stocks, especially of the Dividend Achiever ilk, have a demonstrated history of outstanding financial stewardship.

Be a Fool for dividends
A volatile market gives investors like us two choices: flee to cash, or take refuge in strong dividend stocks. Remember, the latter businesses' payouts, when reinvested, fueled 97% of the market's return from 1871 to 2003.

James Early, advisor for our Motley Fool Income Investor service, is a dividend die-hard. And with good reason; his service's dividend stock recommendations are beating the market, and they boast an average yield of more than 6%. Care to learn more? Click here for a 30-day free trial. You'll get unfettered access to all of the team's research, and James' picks for the best dividend stocks for new money now.

Fool contributor Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. Chesapeake Energy and Wal-Mart are Inside Value picks. Quality Systems is a Stock Advisor selection. The Motley Fool's disclosure policy is 100% of your daily dose of disclosure.


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Comments from our Foolish Readers

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  • Report this Comment On March 30, 2009, at 10:11 AM, Richwhynot wrote:

    There seems to be little new in financial stupidity by the "geniuses" who run this country's companies. The imprisoned thief who destroyed Worldcom (prior to his unmasking) had to bail out of thousands and thousands of out-of-the money call options in Worldcom when he got a margin call. Stock price dropped. He, too, had put up his company's stock as collateral. I guess he had faith that he could cover up his terrible management forever.

  • Report this Comment On March 30, 2009, at 10:48 AM, mikecart1 wrote:

    Wait, you mean Worldcom was an actual company? ;)

  • Report this Comment On March 30, 2009, at 6:15 PM, tonester2k wrote:

    I too have noticed a disturbing trend.

    MF articles with dramatic titles that turn into investing for the long term advice about holding equities with good dividends with strong companies behind them that can survive a depression (duh) and then a commercial for a new MF service.

    Huh...

  • Report this Comment On March 31, 2009, at 9:06 AM, etbean wrote:

    I agree. MF turned into a selling machine instead of the original education tool. Also when one program doesn't work they just start another with different name. I am sorry to see as they become just a selling greedy wall street maney making firm- making money on selling programs that preaty much the same as other financial firm's.

  • Report this Comment On March 31, 2009, at 12:13 PM, cfp1ab wrote:

    Those of you that have been around long enough to know the history of margin accounts, how do you feel about them? I am wondering if they are not more of a curse than a blessing. I am not a huge fan of short selling either maybe I am just too simplistic.

  • Report this Comment On March 31, 2009, at 12:44 PM, paducah5102 wrote:

    Right on! I'm also tired of pulling up these items and finding another "opportunity" to buy yet another publication. MF is becoming too much like all the others. Either give us some information we can use, or stop with the headlines. AND. stop it with all the promotions!!!

  • Report this Comment On March 31, 2009, at 1:36 PM, jaaboo wrote:

    I am also beginning to tire of the continuous hype from MF. What else is out there with good information? I have found The Dividend Detective to be a valuable tool.

  • Report this Comment On April 01, 2009, at 6:07 AM, 8Lives wrote:

    My ex used to work for a gentleman who had an impartial connection to Costco and their financials/business model; and really comends the company for their principals and the integrity with which it opperates. --I've always been more than satisfied as their customer and I'm a Seattleite, so I've been posturing at a target price to invest in them...

    Any Fools with suggestions for target practice??

  • Report this Comment On April 04, 2009, at 10:36 AM, JoeTennessee wrote:

    I agree that MF is too busy trying to sell more subscriptions than giving solid advice. Stop hyping the headlines then I will start listening again.

  • Report this Comment On April 04, 2009, at 12:38 PM, Alex1963 wrote:

    Not to be a suck up but when I first joined MF in Dec'08 I took advantage of 3 of their subscriptions on the 30 day free trial. Some of my best returning Caps picks & RL investments came out of those. I don't understand the criticism. I don't think MF purports itself to be solely an investment chat/blog or non subscription forum. If you don't care to subscribe then why not take what you can from the may helpful articles and move on? Personally I read most everything they write & rarely come away feeling any article was a total waste. Most are well worth the 3-5 mins to read. Meantime I'm sure those who do subscribe help pay the bills to keep this site operating and I for one hope MF makes a bundle if it means they keep this forum open and free.

    Sincerely

    Alex

  • Report this Comment On April 04, 2009, at 6:49 PM, rwjj wrote:

    I agree with many of you.

    TMF is changing into a money making machine, constantly using their email database to drive more subscriptions, enroll in repackaged combinations (a bit like repackaged derivatives) and entice with provocative headlines - sounding more like a Wall Street marketing firm or is it Duke Street than a trusted financial advisory service. It is sad that they have lost their original mission of educating and providing trustworthy advice.

  • Report this Comment On April 11, 2009, at 10:04 AM, PSU69 wrote:

    MF adds to my insights. I do not object to them trying to make a buck with promos. I recently opted out of the snail mail printed stuff to lower their costs. I like MF and I also recommend it. Sure, there is commercial static to sift. Cheaper than Maddoff! How many thieving bums hurt investors. MF is clean. Commercial? Sure. Deal with it and be thankful for the good elements of MF.

    http://www.linkedin.com/in/robnelson44140

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