Sunday, April 23, 2006

The Rising Dividend Story -- Black Monday

No investment strategy comes to a person's mind fully formed. Neither does it come entirely through the intelligence of a wise professor, or the persuasion of an insightful author. An investment strategy a person is willing to bet his or her life savings on is one that has been molded and tested in the fires of adversity and has shown its mettle and its worth. These pages have been full of stories about the merits of rising dividend investing. Many of you who are reading this blog are sold on this strategy; while many of you may think it is just a clever marketing strategy. During the next few weeks, I would like to share with you the story of how I came to understand the hidden value of rising dividend investing. As you will see, the Rising Dividend Story is really a story within a story. I have experienced this story first hand, but it is not mine. Indeed, I was aware of many of the elements of this story years ago, but it took the keen intellects of Mike Hull and Rick Roop and a book written in 1937 to fully understand the breadth and width of the power of rising dividends. I will retell the story as faithfully as possible. But please do not mistake my telling of the Rising Dividend Story for the truth of it. When the truth of it apprehends you, you will see investing with entirely new eyes. I'm not sure whether telling the story will take 10 installments or 20, but we will work our way along in a logical and chronological way. Many of you who are reading this will find yourself included in the story. So many of you have contributed to the Rising Dividend Story that I am dedicating it to the clients of Donaldson Capital Management. While perhaps not suitable for framing, you may wish to pass the story along to friends and family, especially to young adults. Rising Dividend Investing is not the only way to invest, but we believe it is understandable to almost anyone and it works. It allows a person to disconnect from the frantic search for the next hot tip or hot stock and rest in the knowlege that you own real-live growing companies and not a collection of ticker symbols. The Story Begins Black Monday, October 19, 1987, was agonizing, devastating, and surreal, yet from a long-term investment perspective, it was the best thing that ever happened to me. On that day the Dow Jones Industrials fell by 511 points; 22.6% of its value, which would be the equivalent of over 2500 points today. Black Monday’s percentage loss dwarfed the 12.8% one-day loss in the crash of 1929. When I say Black Monday was the best thing that ever happened to me, I do not mean a kind of Dickinsonian best of times and worst of times happening together. From a financial and psychological perspective for me, it was the worst of times. The only good thing that happened as a result of the crash was the destruction of most of my illusions about investing. If you would have asked me prior to Black Monday what stocks to buy, I had a quick answer and I was convinced I was right. My investment strategy was contained in the acronym BIG trend. BIG stood for Big companies that were Industry leaders and Growing. Trend meant I invested only in BIG stocks whose prices were trending higher. I made the claim regularly that in sticking with big companies I could know as much about them as the Wall Street analysts, because big companies were widely covered in the popular and financial media. In focusing on industry leadership, I was merely stating the obvious; that size mattered, and companies that were number one or two in their industries were generally the most profitable, efficient, and valuable. However, I must have said ten thousand times in my life that there were lots of big companies that were leaders in their industries, but few of them were growing. Thus, the core of my investment strategy was that earnings growth was the dynamo that propelled price growth. Finally, since the markets were made up of very bright people with lots of tools for uncovering successful investments, my strategy was to wait until price trends clearly began to move in concert with earnings growth, giving me what I called convergence, and a probable winner.Once I had convergence, I bought the stock and owned it until its price and earnings diverged. Between the two, the price trend was the final word. It was my theory that the so-called “mind of the market”, the millions of investors making buy and sell decisions, would get into a kind of buzz where everyone was looking at the same price and earnings trends. This would pull more and more investors into the buzz and push particular stocks and industries higher. My approach had been successful for many years. I was confident that if I watched the markets closely enough, I could see which way the winds were blowing and which of them held the most promise. Other than the trend of earnings growth, I paid little attention to the valuations or fundamentals, such as P/E, sales, and dividends. I believed that my best chance of success depended on watching the trends and not the values. On Black Monday, the price of every stock suddenly collapsed. Ironically, the crash was made worse because there was no negative economic or political news that appeared to be fueling it. The market just seemed to implode. The companies I owned in my clients’ accounts were still big, industry leaders, and growing, but not a single one now had a friendly trend. All stocks were headed down. The strategy I had used for years was saying to sell everything, but as I thought about the wisdom of selling all the stocks under our management, I found myself recoiling. It flashed through my mind that it made absolutely no sense to throw good stocks at bad prices. I could feel it in my bones that something was wrong with the markets and not our companies, but I was now faced with the dilemma of ignoring my long-established strategy of selling stocks that had broken rising price trends. At the moment I decided not to sell everything, I realized I was cut adrift from any experiential confidence I possessed. If I ignored sell signals, then when did I sell? And perhaps, if I was not willing to throw good stocks at bad prices, I should be taking advantage of the collapse and start buying. These questions cycled through my mind continuously. As they did, a strange sense of unknowing took up residence in me, and I came face to face with the reality that the BIG trend investment strategy that I had followed for so many years was at an end. Circumstances had shown it was suitable only for “fair weather” investing, and the weather had turned as bad as it had been in 60 years. Yet, having said this, the sense of unknowing was not a feeling of hopelessness or confusion. I had an intuitive feeling that there was no smart way to escape the crash, and the most important thing to do was to keep things very simple and avoid emotional responses both in myself and in my clients. Short of another 1929 depression, the companies we owned would make it through these times, and I knew when things calmed down, they would be the first to rebound. As Black Monday wore on and the telephone calls from frightened clients kept coming, I realized that I had few answers for them. Even if they insisted on selling, the market was running so far behind that the prices I saw on my screen, at times, were an hour behind the actual trading. It was anybody's guess what a person would actually receive for the sale of a stock. A big day for the Dow Jones at that time was a positive or negative change of 20 points. The market opened the day down 200 points before rallying back to down only 80 points by mid morning . When it again fell by over 200 points, something inside of me gave way, and I knew the market was going a lot lower before the end of the day. Lower than I could have ever imagined. As the market continued to fall through each succeeding 100 point drop, I found myself with a growing recognition that the crash would likely do as much psychological harm as financial harm. It also posed a serious threat to the existence of the small investment firm that I had helped start in the previous year. I had been in the investment business for 12 years, and this small investment firm was the culmination of my dreams. This would be a battle not only to protect our investor’s assets, it would also be a battle to save our company.