BP shareholders learned a hard lesson in 2010 about the risks that do not show up on balance sheets. If you had to choose between Chevron, Exxon, Royal Dutch Shell, and BP on January 1st, 2010, it would not be clear which of those companies carried the highest risk of earnings impairment.
Even if BP disclosed the specifics regarding the Deepwater Horizon oil rig to investors, it would not be clear that the machinery carried a high risk of explosion–over $30 million was spent on safety equipment that conformed to the industry’s safety standards. In fact, BP’s behavior was so consistent with the rest of the oil industry that I disagreed with Judge Barbier’s ruling that BP committed gross negligence rather than negligence.
Regular negligence refers to when you should have done something but messed up; gross negligence was born out of Alfred the Great’s “Doom Book” put together in the 9th century in which he attempted to combine Mosaic code, Christian principles, and Germanic customs. Alfred the Great created courts with two judges–a sheriff and a Catholic clergymen. The sheriff’s job involved measuring the amount of damage, and the Catholic priest would measure the moral responsibility of the accused wrongdoer. The earliest form of gross negligence meant that you were so careless that it was morally equal to intentionally causing harm. The United States courts have defined this term to mean an extreme and careless disregard for duty.
When you meet the industry standard and spend over $30 million in safety equipment on a vessel, I find it fair to conclude that a resulting explosion breached a duty (negligence) but I am unconvinced that a duty was breached with extreme and careless disregard for the duty (gross negligence.) This distinction matters because it is the difference between BP paying $7 billion and $21 billion in the oil spill aftermath.
I mention all of this to say that there is a certain unpredictability that comes with the territory of investing. If you read the BP annual report in 2010, nothing would have prepared you for the oil spill. There was no indication that BP equipment had a risk of causing exceptional environmental damage, as the safety spending and equipment obtained was the same that all of the other energy giants were using. Even after that, it would not have been obvious to predict that BP was on the hook for triple damages due to a judge finding that the oil spill was the result of extreme disregard for safety duties in the leadup to the spill.
The natural follow-up question, then, is this: How should events like the BP oil spill inform portfolio construction?
Everyone defines diversification differently, but the test I apply is this: Could you make peace with a particular holding going bankrupt? Could you maintain your lifestyle? Of course it would be unpleasant to have your largest holdings disappear, but there is a difference between something you look upon five years later as a mild annoyance compared to the big mistake that derailed your lifestyle.
The way you choose to handle dividend reinvestment can go a long way towards minimizing this risk. Every time you reinvest a dividend back into the company that paid it, you are escalating your commitment to that company. If you own Kellogg for thirty years, there will be 120 instances in which you raise your financial commitment to the company if you choose to auto-reinvest the dividend.
It seems wise to me to pool together dividends that come from the following sources: banks, technology, big box retail, tobacco, utility companies that generate profits from nuclear plants, or the materials sector. On the other hand, industrials with no or minimal financial arms, consumer staples, healthcare, and certain niche industry companies like Disney or Nike make strong candidates for perpetual reinvestment. My opinion on energy companies is context specific–if you own all five supermajors, it can be wise to auto-reinvest into all, whereas someone with only one oil holding may want to pool the dividends together with others.
What I just wrote is best applied for someone that is driven by loss aversion rather than a desire to maximize gains. The upside of following the above strategy is that you can do things like buy Kodak in 1990, collect the cash dividends from Kodak as well as collect the spun-off company Eastman Chemical and the dividends it provides, and generate 7.5% annual returns from 1990 through 2014 despite the parent company Kodak going bankrupt. Decades of dividends and a spinoff company can provide great protection that isn’t usually picked up by media analysts that look at a company’s all-time high price and then compare that against the bankruptcy.
This advice is also driven by a desire to avoid what I call “Wachovia Syndrome.” For decades, Wachovia was the pristine image of a high-quality, no-nonsense bank. The loan portfolio grew by over 7%. The earnings grew around 11%. The dividend went up every year. The long-term growth rate was so impressive that the bank became the 4th largest in the United States in 2007, dotting the eastern landscape with thousands of bank branches. A $10,000 investment in 1965 grew to $4 million by 2007 with dividends reinvested.
Yet, shareholders soon experienced a $130+ billion market cap loss that was their holdings tumble over 85% once the financial crisis hit, only to be bought out for $15.1 by Wells Fargo (receiving almost 0.2 shares of Wells Fargo stock for every share of Wachovia held.) Wells Fargo stock has almost doubled since that time, so there has been some mitigation. Still, over 70% of the wealth from the 2007 peak has been lost.
For someone that collected dividends as cash along the way, the person would have collected $800,000 in cash between 1965 through 2007 though the value of the account would have been $2.0 million in Wachovia stock + $800,000 in cash dividends for a total of $2.8 million at the time of the financial crisis. The person who collected dividends would have known that he collected his initial investment back 80 fold over 42 years, and could have made even more money once you adjust for the opportunity cost (e.g. you wouldn’t have the dividends sit in a bank account as cash for 42 years.) If you do this, you can have a more peaceful attitude when crisis strikes–you would have already been well taken care of by the investment, and deep turmoil won’t jilt you into seeing your life’s work vanish before your eyes during crisis. No one wants to spend their life building something, only to disappear once they need to rely on it.
This defensive tactic of collecting dividends from the company treats each dividend as a rebate that reduces the potential harm the investment can cause you in the event of failure. In the next ten years, someone owning Chevron stock will collect around 75% of the purchase price in dividends from his stock holding. By 2027 or 2028, you might collect your entire Chevron initial investment back as dividends. In some sense, you will be playing with house money–you got your upfront cash back, plus you’d have the “free” Chevron holding still chugging out dividends.
Now, I mention that this is not as effective of a tactic for maximizing wealth. For someone that owned tobacco stocks over the past three decades, the decision to collect dividends as cash over the past three decades would result in a substantially smaller net worth. That is because each reinvested tobacco dividend in Reynolds, Lorillard, or Altria went on to compound near 20%, compared to the 9% or so you would get by selecting a company that performed in line with the S&P 500 averages. But still, given the excessive litigation of the time, in addition to the declining volumes of tobacco shipments, the decision to divert dividends elsewhere would have been rational at the time given the realistic worst-case scenarios that existed at the time.
There is also a life cycle element to all of this. If you are just getting started, or the dividend amount is analogous to beer money, then you should automatically reinvest and not worry about it. Take those Southern Company dividends and turn those 100 shares into 105 shares over the course of the year. When the dividend amounts are in the tens or hundreds of dollars, your focus should be on generating surplus cash to build the portfolio and letting the dividends reinvest so that the position can become something of substance.
But if you are in your 50s and sitting on 5,000 shares of Southern Company that accounts for 18% of your overall wealth, the portfolio management should be different. Take that $2,700 dividend check and combine it with the pooled ones to make an investment in Johnson & Johnson or something.
Once a meaningful portfolio is built, the guiding question should be: “What outcome do I want to avoid, and what deliberate actions can I take to reduce the probability of that undesirable outcome?” The chief outcome to avoid for most of you is going to be this: You don’t want to spend your life buying something over and over again through reinvested dividends only to see it disappear. Certain industries carry a higher risk of this happening than others. If the dividend comes from an at risk industry, you should gradually de-escalate by taking the dividends and putting them elsewhere. With a lot of companies that yield 4% or more and offer modest growth of the dividend, you can be playing with house money within fifteen years.