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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 SRI Surgical Express.

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
Smart investors prepare their portfolios for Financial Armageddon, knowing that even with the S&P 500's 10% rally this year, losses could revisit us at any moment. We've seen sucker rallies before, and we're likely to see them again.

Which naturally begs a question: 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?

Toxic stocks are still out there. Look at the banks. But the market always produces its share of winners, and in 2008 -- a toxic year if ever there was one -- companies that generated free cash flow, maintained sturdy balance sheets, and paid dividends did better than most.

Piedmont Natural Gas (NYSE: PNY  ) , for example, was one of last year's rare stock market winners. This energy services company 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 Innophos (Nasdaq: IPHS  ) , Monro Muffler Brake (Nasdaq: MNRO  ) , and Public Storage (NYSE: PSA  ) .

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 Airgas (NYSE: ARG  ) , MCG Capital (Nasdaq: MCGC  ) , and Packaging Corp. of America (NYSE: PKG  ) -- 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 are firms 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 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 4%. 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. Innophos is a Hidden Gems recommendation. The Motley Fool's disclosure policy is 100% of your daily dose of disclosure.


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