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 Heartland Payment Systems (NYSE: HPY  ) . Chesapeake Energy 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, and we've seen our share of panic 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 was. April and May, too, helped my frayed nerves. And yet, even with these gains, the S&P 500 is only even for 2009.

Losses could revisit us at any moment. Mr. Market is like that. Can there be any hope for buy-to-hold 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.

Ross Stores (Nasdaq: ROST  ) , for example, was a rare stock market winner in 2008. The retailer 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 market beaters from last year include Wal-Mart (NYSE: WMT  ) , American Woodmark (Nasdaq: AMWD  ) , and Darden Restaurants (NYSE: DRI  ) .

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 Macerich (NYSE: MAC  ) and Natus Medical (Nasdaq: BABY  ) -- 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. Yet even dividends won't exempt you from the market's short-term craziness, when hedge-fund selling can send stocks down, or when a CEO's margin bet can go very, very wrong.

So don't settle for just any dividend payer; cuddle instead with the Dividend Achievers. These are companies with a demonstrated history of outstanding financial stewardship.

How to be a Fool for dividends
A volatile market gives investors like us two choices: Flee to cash, or take refuge in strong dividend stocks. Choose cash if you must, but before you do, remember that reinvested dividends from top companies  fueled 97% of the market's return from 1871 to 2003.

James Early, advisor for our Motley Fool Income Investor service, is a dividend diehard. 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.

This article was first published March 29, 2009. It has been updated.

Fool contributor Tim Beyers owned no companies mentioned here at the time of publication. Chesapeake Energy is an Inside Value pick. Heartland Payment Systems and Natus Medial are Motley Fool Hidden Gems recommendations. The Fool's disclosure policy is 100% of your daily dose of disclosure.


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  • Report this Comment On June 01, 2009, at 3:04 PM, madmilker wrote:

    People in America need to realize jus what got America in this shape…”cheap” yes so-call cheap items from a foreign land.

    quote*Wal-Mart firmly believes in local procurement. We recognize that by purchasing quality products, we can generate more job opportunities, support local manufacturing and boost economic development. Over 95% of the merchandise in our stores in China is sourced locally. We have established partnerships with nearly 20,000 suppliers in China. *end quote!

    Now! if there be 182 country’s making items for the world to buy and they have only 5% of the pie in China…duh! This company makes the nice people of China support their currency(yuan) by keeping it in their country working for the people there…. but with the “yuan” going up in value and the US dollar going down…all the foreign items that the American consumer buys thinking it is cheap has went up in price.

    People…its all about the currency and to keep a currency strong you got to keep it floating around the country you live in so it can work for you. For the past 12 years all them US dollars are being shipped overseas to a foreign bank and with the American worker not making anything for the foreigner to buy the “we the people” have to turn to the “second” largest employer in America(Uncle Sam) to sell “we the people” debt in order to get all them dollars back!

    50 years ago a foreigner would had given their left nut for a US dollar or a Hershey’s chocolate bar and today the same foreigner has got Uncle Sam and the American consumer by both all the while Hershey is moving the chocolate factory to Mexico. Wake up! America and think “MADE IN AMERICA.”

    quote*"Considering that there are over 30,000 ships at sea this morning," writes James Carlton, director of the Williams College-Mystic Seaport Maritime Studies Program, in an e-mail, "the total number of organisms and species in this global 'bioflow' on the morning your readers read your piece could be staggering - billions of individuals, and thousands of species."

    Indeed, scientists have long considered ballast water the primary way invasive aquatic organisms are introduced. From the zebra mussel's arrival in the Great Lakes, to an American jellyfish severely disrupting Black Sea fisheries, the potential costs of accidental introduction of a species to new homes can be tremendous. Aquatic invasives cost the US $9 billion yearly, according to estimates by David Pimentel, professor emeritus of ecology and evolutionary biology at Cornell University in Ithaca, N.Y. Zebra and quagga mussels (a cousin to the zebra) alone cost the $1 billion annually.*end quote!

    tat is $9 billion a year in hidden taxes to all Americans...

    cheap ain't chic and it cost America............jobs!

    quote*Now let us look at Wal-Mart again; you buy a product there, 6% goes to the employees, 10-18% is profit to the company, 25% goes to other costs and 50% goes to re-stock or the cost of goods sold. Of the 50% about 20-25% goes to China, a guess, but you get the point. Now then, how long will it take at 433 Billion dollars at year for China to have all of our money, leaving no money flow for us to circulate? At a 17 Trillion dollar economy less than 40-years minus the 1/6 they buy from us. Some say that if we keep putting money into our economy, it would take forever, but if we do not then eventually all the money flow will go. If China buys our debt then eventually they own us, no need to worry about a war, they are buying America, due in part to our own mismanaged trade, so whose fault is that? Not necessarily China, as they are doing what's in the best interests, and we should make sure that trade is not only free, but fair too.*end quote!

    http://www.worldthinktank.net/pdfs/TheFlowofTrade.pdf

  • Report this Comment On June 01, 2009, at 3:35 PM, retry77 wrote:

    Madmilker, why don't you save your preaching for Obama who is systematically destroying corporate America.

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