You Are About to Lose a Fortune

I've noticed a disturbing trend: more executives are being forced to sell because of margin calls.

Chesapeake Energy CEO Aubrey McClendon forfeited virtually his entire stake in the company he co-founded 20 years ago. More recent victims include insiders at Sterling Construction (Nasdaq: STRL  ) .

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 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.

Church & Dwight (NYSE: CHD  ) , 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 winners from last year include Nordic American Tanker Shipping (NYSE: NAT  ) , GlaxoSmithKline (NYSE: GSK  ) , and Cal-Maine Foods (Nasdaq: CALM  ) .

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 Eagle Materials (NYSE: EXP  ) and GSI Commerce (Nasdaq: GSIC  ) -- 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, where hedge fund selling can send stocks down, or where 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 firms boast 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 firms 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 5%. 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 didn't own shares in any of the companies mentioned in this article at the time of publication. Chesapeake Energy is an Inside Value pick. The Motley Fool's disclosure policy is 100% of your daily dose of disclosure.

Read/Post Comments (2) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 02, 2009, at 4:22 AM, thisislabor wrote:

    so can i just ask, is that 97% of the market's return caused because 97% of the companies in the market issue dividends, and only 3% do not?

    i mean, i am just imagining here if all companies instead were like microsoft and didn't issue a single dividend what would happen (besides the fact that no one would buy the companies stock because now it is a useless piece of paper....).

  • Report this Comment On July 04, 2009, at 8:23 PM, streetflame wrote:

    TIL: No, only about 1/3 of US stocks pay dividends.

    And by the way, MSFT does issue dividends. Maybe you were thinking of another tech company.

Add your comment.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 932982, ~/Articles/ArticleHandler.aspx, 10/25/2016 12:04:55 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 18,178.22 -44.81 -0.25%
S&P 500 2,144.76 -6.57 -0.31%
NASD 5,288.47 -21.35 -0.40%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/25/2016 11:48 AM
CALM $38.03 Up +0.03 +0.07%
Cal-Maine Foods CAPS Rating: ****
CHD $48.17 Up +0.84 +1.77%
Church and Dwight CAPS Rating: ***
EXP $81.01 Up +1.18 +1.48%
Eagle Materials CAPS Rating: ****
GSIC.DL $29.54 Down +0.00 +0.00%
GSI Commerce, Inc. CAPS Rating: **
GSK $40.35 Down -0.33 -0.81%
GlaxoSmithKline CAPS Rating: ***
NAT $9.22 Down -0.07 -0.75%
Nordic American Ta… CAPS Rating: ***
STRL $7.74 Down -0.05 -0.64%
Sterling Construct… CAPS Rating: *****