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
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
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
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.
