I've noticed a disturbing trend on Wall Street: More executives are being forced to sell because of margin calls.
Recent victims include insiders at Cedar Fair
A more than marginally bad idea
Margin is debt. When you buy stocks 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.
Company 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 (from hedge and mutual funds, for example), which depresses prices. That, 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 gains the market notched in March. The S&P 500 is still off more than 5% in 2009, but it was down some 25% at the end of February.
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.
Family Dollar Stores
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 United Therapeutics
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.
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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. United Fire & Casualty is a Hidden Gems recommendation. The Motley Fool's disclosure policy is 100% of your daily dose of disclosure.