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Dividend-Investing and Stop-Losses: Stop the Madness

By Roger Conrad on February 18, 2011

Consensus projections, “whisper” numbers, guidance: All are part of the expectations game Wall Street plays each earnings season.

In a good market companies that do better than expected can gain considerable ground in a short time. In a weakening or uncertain market stocks that disappoint can lose a lot of ground in a hurry.

There is, however, considerable ambiguity in what it means to meet, beat or lag expectations. Sometimes, for example, a company will exceed expected earnings per share (EPS), only to tumble because it missed a revenue growth number. Other times, the headline earnings number reported in the popular media will be wildly above or below projections, but the stock will hardly react at all.

Dividend-paying equities are traditionally thought of as being less volatile than other stocks, as their yields give them stability. Ironically, in recent months the expectations game has affected them even more than the rest of the market.

One explanation is the now widespread use of stop-losses by conservative investors. These sell you out when a stock falls below a certain level. “Trailing” stops in particular have become very popular, as the stop price constantly ratchets up as the stock’s price rises.

More than a few income investors have fallen prey to the misconception that stop-losses will protect them against downside in their dividend-paying stocks, which they’ve grown progressively fearful of in an environment of rising prices. Unfortunately, setting a stop doesn’t guarantee a specific exit price.

All it really does is assure you’ll be sold out if a certain price is breached. If there’s enough volume at a certain level, a relatively minor drop in a stock can quickly turn into a waterfall decline, as sell orders temporarily overwhelm the buyers. Your actual selling price can be well below your “stop” price.

The good news is this type of drop is almost always quickly reversed. Recovery will take longer if the entire market is melting down, as was the case in the 2008-09 historic plunge and, to a lesser extent, during last year’s Flash Crash. But buyers will come back. In fact, in a normal market most of the lost ground will be made up the same day.

Those who hang in there–i.e., who don’t have stops in place–will no doubt experience some nervous moments. But ultimately as long as they don’t panic they’ll be made whole.

Thus far in fourth-quarter and full-year 2010 earnings season, the majority of surprises have been on the upside, at least for companies in the Utility Forecaster How They Rate coverage universe. As a result, stock prices have generally risen following their earnings announcements.

This group includes the eight companies whose numbers I’ve reviewed in this report for Utility Forecaster Weekly readers. With nearly half the companies still left to report, however, there’s still the potential for disappointment, and consequently selloffs in our favorite stocks.

That’s item No. 1 for consideration as Wall Street’s expectations game plays out in the next few weeks. If and when we do see such a selloff, the key will be to discern whether it’s due to ephemeral factors such as missing a growth number, or is a sign of real weakness in the underlying business.

If it’s the former, the lower price will invariably mark an opportunity to buy. As I’ve pointed out, many of my recommendations have been trading above my buy targets, levels where rewards for buying (earnings and dividend growth) outweigh the risks. A selloff caused purely by a reaction to a missed number has little consequence for investors those interested in garnering high yields and long-term wealth building. Therefore, it’s often a great buying opportunity.

On the other hand, numbers that point to a weakening underlying business should always be heeded as potential “sell” signals. But the most important of these aren’t Street expectations. Rather, they’re companies’ own profit guidance–on which they base their capital spending, debt and dividend policies.

This is the most important metric for investors to pay attention to. Management in conference calls and earnings releases will always paint the prettiest picture they can. That, after all, is what they’re paid to do. And the better the investment world believes their prospects to be, the lower their cost of capital will be and the easier their road to success.

I’ve found some companies’ managements will always low-ball their projections, which sets up a game with the analysts who know full well what they’re doing. What I look for is consistency. That is companies setting a target when the year begins and then consistently hitting at least the mid-point of that range–and doing that year after year.

The nice thing about essential-service companies is there’s a great deal of transparency about future numbers. Demand for electricity, water and communications, for example, is fairly inelastic. That is, it doesn’t shift much with economic swings, a point once again underscored during the 2008-09 market crash/credit crunch/recession.

Rather, what moves the needle for earnings is always capital spending, and companies’ ability to earn a fair return on it. Even essential-service companies that earn a fair chunk of earnings in unregulated and commodity price-sensitive markets can hedge their exposure to the unknown. Therefore, if they can grow their assets, they can grow their earnings.

As a result, companies make their targets most of the time. The exceptions are when management miscalculates. And when that’s in the negative–or shows signs of being so–it’s often time to bail out. That’s particularly true in this environment, mainly because yield-chasing investors aren’t selling until real disaster is upon them. You can avoid a potentially dangerous situation and get out at a premium price.

The higher dividend-paying stocks’ prices go, of course, the easier it will be to disappoint investor expectations. Therefore, it’s not likely to be so easy for companies to beat projections in subsequent quarters, and the damage from a missed number will be that much more severe.

Such is the risk of a bull market that gets long in the tooth. In fact, increasing difficulty in meeting escalating investor expectations is the number one potential catalyst to bring down stock prices in 2011.

If you’re being paid to manage the near term, the short-term implications of meeting or missing Wall Street expectations–however they’re measured–are absolutely critical to your success. To these people it makes absolute sense for a stock to tumble in the wake of a missed number, or to soar if a company does better than anticipated.

On the other hand, if your goal is long-term wealth-building and garnering income, whether a company is “light” on fourth-quarter revenue or cash flow is basically meaningless, other than it may depress the value of your stock in the near term.

The key rather is whether or not your company is still on the course management set and is therefore basing its business, growth projections and dividend on. As long as that’s healthy, there’s no reason to do anything in response when the market reacts to a number.

Simply, your objectives are different than they are for someone who is being evaluated on how they do from month-to-month, quarter-to-quarter or even year-to-year. And it’s absolutely critical to your dividend-investing success that you put money to work with that in mind.

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