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Dividend Investing and Technical Analysis: Three Rules

When a stock’s price drops 10 percent in a week, should you buy, sell or just do nothing? What if that drop occurs in a day? Suppose over the past couple months a stock you own has made a succession of lower highs and lower lows. Should you infer the bottom is about to fall out?

These are the kinds of questions I’m getting more and more often from readers. That’s remarkable, considering that in 25 years-plus as an investment advisor I’ve never been known as a chart-watcher.

Yes, my advisories have plenty of graphics and I definitely talk at lot about price performance and what it means. But I’ve also never found the basic rules of what’s called “technical analysis” to be particularly useful for income investors. In fact, more often than not buying and selling based on even the most basic rules–i.e., selling when a stock cuts below its 200-day moving average, etc.–will cut you out of dividend checks. And, as we’ve seen routinely over the past few years, today’s downturn usually becomes tomorrow’s rally.

Rather, if you’re investing for income your focus should always be the health of the underlying business. As long as your companies are healthy and growing, they’ll maintain and increase dividends. Over time stock prices will follow those dividends higher, so buying and holding will net you capital gains as well.

Some companies are better suited for paying out big dividends over time than others. For example, those providing an essential service such as water or natural gas distribution can count on steady revenue even if the economy is in a tailspin. Such companies are exceptionally good dividend payers over the long haul.

In contrast, a company whose primary business is holding mortgages may find itself periodically wracked by defaults and tightening credit conditions. It can dish out a lot of dividends for a season. But when the environment turns harsh dividend cuts are the rule rather than the unlucky exception, as is the case for utilities.

That’s why my advisories’ model portfolios are always focused on companies that have strong underlying businesses conducive to paying out big dividends for the long haul. And I’m constantly looking at earnings, management guidance, strategic moves and other action on the ground to determine if my companies are still up to standard.

As long as they are I’m likely to stick with them. No matter what happens to their share prices in the near term, they’re going to finish the cycle higher, as dividends ratchet up and bring stock prices up with them. Only if they falter will I sell.

Investors who do follow technical analysis, of course, have a far different view. Many maintain that all you need to know about a stock can be gleaned by a look at its price chart. And there are certainly investors and advisors that have been successful following various strategies based on chart-watching.

My view is there are many potential paths to success in investing. None of them are perfect and all have strengths and weaknesses. The key is that investors must have the discipline to stick to them. Those constantly switching horses in midstream not only are not going to see the other side. But they’re constantly at risk to being swept off with the current.

Neither, however, do I think anyone should be dogmatic about their approach, and there are always grounds for improvement. And there are definitely ways income investors can use charts to their benefit. Here are few that figure to be useful for the rest of 2011 and almost surely well into 2012.

Price graphs of individual stocks are the best window into investor perception of dividend risk. As I’ve pointed out before, interest rates are no longer calling the tune for dividend-paying stocks. In fact, the so-called interest rate-sensitive link has been smashed for the better part of four years. Rather, it’s investor perception of risk to dividends that’s driving share prices.

Stocks operating in businesses considered ultra-safe, for example giant water utility American Water Works (NYSE: AWK), have not only experienced minimal volatility the past six months, but have continued to trend higher. In stark contrast, stocks in industries with a lot of perceived dividend risk–such as rural wireline company Frontier Communications (NYSE: FTR), have been both highly volatile and trending down.

We’ve seen the yield spreads between perceived safe and risky industries expand and contract markedly over the past six months. The past couple weeks spreads have widened markedly. That makes now a good time for taking calculated risks, buying companies with huge yields that are still producing the earnings to pay those dividends.

The market’s already pricing in a stumble, which limits downside risk. And if management perseveres, you’ve locked in a huge yield and big capital gains, as perceived dividend risk inevitably wanes and the spread narrows.

Note that under no circumstances do I advise investors to average down in such high-yield situations. Market history demonstrates that only a small fraction of companies stumble and actually fall during broader downturns. This includes the historic 2008 market crash/credit crunch and recession. But some companies did indeed evaporate. And those that really loaded up on them got crunched. Be smart and be diversified, and this bit of chart-watching will pay off big.

Dramatic price changes in a stock sometimes do indicate a company’s underlying business is weakening. In a strong market you can pretty much count on a dramatic drop in a stock’s price to indicate some kind of business weakness. In a fear-drenched market like this one, you can’t count on that to be the case. In fact, some of the worst declines I’ve seen the past few months have occurred after the company announced what were clearly positive developments, such as solid earnings and dividend increases.

There are times, however, when the drop in the stock is due to the fundamentals, and they’re always worth paying attention to. As readers to my advisories know, my model portfolios generally have very little turnover. Once I enter a position, I usually stick with it. But that doesn’t mean I’m not constantly watching the daily trading of my recommended positions. And whenever there is a big move in a stock, I want to know why as soon as possible, even if I don’t do anything in response.

The first place I’ll look is at the company level. Has management announced something to trigger the buying or selling? The most important of these will be anything directly affecting the dividend. If that’s not the case, I’ll look for anything that might have happened to increase or decrease future risk to the dividend.

If there is something there, I will reassess my position in the stock. If there isn’t I’ll stick, but I still want to know why the price has risen or fallen.

That might be as easy as just scanning headlines or looking at what happened to the overall market that day. The big money that moves the market on a daily basis could care less about the strengths or weaknesses of any individual stock–particularly when, for example, Europe’s sovereign debt crisis seems to worsen.

A really bad day will take down even stocks announcing big dividend increases. Again, that kind of action is a reason to buy, not sell. But you don’t know that until you take a look, and that’s why I always investigate when a stock I own has dropped.

Downgrades of particular stocks by analysts present some gray area here. In an “up” market, a cut in a rating from buy to hold usually triggers at least some action. But in this fearful market, downgrades can incite panics. In my view it goes back to many investors simply not trusting their own eyes and therefore being afraid to make up their own minds.

If an analyst suddenly switches from bull to bear, I want to know why. They may have a good reason. But I’m not going to just assume they know more than anyone else. And I’m actually more impressed if there’s insider buying.

Watch price trends of commodities that can affect earnings of companies you own as well as interest rate trends. Oil prices affect oil company earnings. Natural gas prices are key to gas-producer profits. Interest rate swings can have a huge impact on companies that need to refinance large amounts of debt or that need to raise capital for their business plans.

I continue to advise steering clear of any company that will be heavily reliant on the health of credit market between now and the end of 2012. That includes companies with big debt maturities between now and then, defined as greater than 10 percent or so of market capitalization.

The good news is most companies have been terming out debt on an unprecedented scale, taking advantage of record-low corporate borrowing rates to extend maturities at lower costs. Even if Europe collapses and credit conditions tighten in the US, they’ll simply be able to take a step back and postpone new borrowing until they can get a lower rate again.

That’s a stark contrast with 2008, when many were caught with big borrowing needs. But there are still companies that are subject to what amounts to a margin call, should tighter credit result in their being shut off from capital markets and induce bank lenders to force dividend cuts as the price of continuing support.

Some industries must constantly access credit markets to maintain operations. They include mortgage real estate investment trusts, and I would avoid them despite their current monster yields.

I’m not holding out a lot of hope for rising natural gas prices anytime soon. In fact the current near-term futures contract has now fallen to just $3.39 per million British thermal units. That’s not much above the five-year low of roughly $2.75, or even the 10-year low of $2.03 last seen in September 2001.

The problem for gas, for the time being at least, is that new supplies from shale are growing faster than demand. There are still plenty of ways to make money in gas, but only in companies that are ramping up production efficiently and/or providing infrastructure to get the fuel to market such as pipelines. These companies have bright futures. In fact the longer gas stays cheap, the more money they stand to make.

As for oil, even bottlenecked West Texas Intermediate crude is having another run at $100 a barrel. And that’s despite the market’s constant focus on events in Europe and the risk of another recession.

Companies that depend on oil and can be hit hard by rising prices are thankfully fewer these days than at any time in the last 50 years. But only the very intrepid and extremely picky should be delving into airlines stocks. Hawaiian Electric Industries Inc (NYSE: HE) is the only US utility that relies heavily on oil to provide electricity, 80 percent at last count.

Management is working hard to reduce that, mainly through a huge investment in renewable energy that’s also expensive but not subject to the wild price swings that plague oil. It, too, should be viewed with extreme caution, however, particularly because other US utilities don’t share its potential vulnerability.


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Stock Talk

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Mika

Below is just a little information on this topic from my small unique book “The small stock trader”:

The most significant non-company-specific factor affecting stock price is the market sentiment, while the most significant company-specific factor is the earning power of the company. Perhaps it would be safe to say that technical analysis is more related to psychology/emotions, while fundamental analysis is more related to reason – that is why it is said that fundamental analysis tells you what to trade and technical analysis tells you when to trade. Thus, many stock traders use technical analysis as a timing tool for their entry and exit points. Technical analysis is more suitable for short-term trading and works best with large caps, for stock prices of large caps are more correlated with the general market, while small caps are more affected by company-specific news and speculation…:

Fundamental analysis

Perhaps small stock traders should not waste a lot of time on fundamental analysis; avoid overanalyzing the financial position, market position, and management of the focus companies. It is difficult to make wise trading decisions based only on fundamental analysis (company-specific news accounts for only about 25 percent of stock price fluctuations). There are only a few important figures and ratios to look at, such as:

• EPS/Revenue
• Cash/EBIT(TA)
• Margins
• Debt
• Management
• Products
• Shareholders
perhaps also:
• ROE
• P/E
• Dividend yield

Furthermore, single ratios and figures do not tell much, so it is wise to use a few ratios and figures in combination. You should look at their trends and also compare them with the company’s main competitors and the industry average. Preferably, you want to see trend improvements in these above-mentioned figures and ratios, or at least some stability when the times are tough.

Technical analysis

Despite all the exotic names found in technical analysis, simply put, it is the study of supply and demand for the stock, in order to predict and follow the trend. Many stock traders claim stock price just represents the current supply and demand for that stock and moves to the greater side of the forces of supply and demand.

If you focus on a few simple small caps, perhaps you should just use the basic principles of technical analysis, such as:

• Price and volume
• Support and resistance
• Trends and moving averages

I have no doubt that there are different ways to make money in the stock market. Some may succeed purely on the basis of technical analysis, some purely due to fundamental analysis, and others from a combination of these two like most of the great stock traders have done (Jesse Livermore, Bernard Baruch, Gerald Loeb, Nicolas Darvas, William O’Neil, and Steven Cohen). It is just a matter of finding out what best fits your personality.
I hope the above little information from my small unique book was a little helpful!

Mika (author of “The small stock trader”)

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