Knowing how much patience to exercise with an underperforming holding is one of the hardest (and often most humbling) challenges in investing, in my opinion.
As a long-term dividend growth investor, when I purchase shares of a company, I hope to hold my ownership stake forever and keep portfolio turnover as low as possible.
Of course, that doesn’t always happen. The world is always changing, upending investment theses and changing the market’s winners and losers.
There are two primary reasons why I will sell a holding: (1) I believe the company’s long-term outlook has permanently changed for the worse; (2) the company’s dividend is at real risk of being cut, which jeopardizes my income stream and potentially my ability to preserve capital.
These judgment calls are not always clear given the wide range of variables impacting a company at any given time. Unfortunately, General Electric (GE) is the latest example.
While I still believe General Electric has a promising 3- to 5-year outlook and is not a business that is rotten to the core, the company’s latest earnings release provided clarity that GE’s dividend will almost certainly be cut in November.
This past Friday, General Electric slashed its 2017 earnings per share guidance by 35%, lowering its target from a range of $1.60 – $1.70 to $1.05 – $1.10 (compared to annual dividends of $0.96 per share).
Most of the company’s segments actually performed well, but those gains were more than offset by weakness in GE’s power generation segment and continued softness in oil & gas markets.
The company’s estimate for 2017 industrial cash flow also decreased significantly from earlier guidance of at least $12 billion to just $7 billion, driven by lower volumes in power, oil & gas, and renewables.
Higher inventory, increased working capital levels, one-time tax costs, and cash restructuring spending further reduced GE’s industrial cash flow estimate.
Analysts and investors were already expecting pretty bad news this quarter, reducing estimates and driving GE’s stock price down by more than 25% year-to-date. However, management’s earnings and cash flow update was worse than even the lowest analyst estimate.
As a result, GE’s stock dropped by as much as 7% in early trading on Friday, although it recovered throughout the day to end with a modest gain.
Investor uncertainty remains high, as demonstrated by GE’s latest pullback today, as investors continue speculating about the company’s new strategic plans, updated capital allocation framework, and 2018 guidance that will be revealed by GE’s new CEO John Flannery on November 13th.
While we will know a lot more in November, as far as income investors are concerned, General Electric’s report last week did not provide good news about the company’s future dividend.
What Friday’s Report Means for GE’s Dividend
One of the main reasons why I have held onto GE’s shares since July 2015 was because I still liked the company’s long-term outlook and believed it had the strength to continue paying its dividend while investors waited for better times ahead.
A wave of major leadership changes over the past six months, coupled with much worse-than-expected cash flow, changed that outlook. Given what we know now, I expect General Electric to announce a significant cut to its dividend on November 13, likely between 25% and 50%.
General Electric’s dividend currently amounts to approximately $8 billion per year. After cutting its 2017 industrial cash flow guidance by nearly half to $7 billion, the funding gap is now very stressed.
Assuming several billion dollars of necessary capital expenditures, perhaps only $3 billion to $4 billion of industrial free cash flow is available to fund GE’s $8 billion dividend.
The company has been receiving cash dividends from GE Capital related to the sale of most of its assets several years ago, which has helped bridge the gap, but this is not a sustainable source of funding.
General Electric also postponed the decision to pay GE Capital dividends to GE due to an insurance actuarial review, which further strains short-term cash flow.
Back to industrial cash flow, management made clear that several billion dollars of one-time, non-recurring cash charges are in the $7 billion figure for 2017 and that 2018 will get more benefit from the company’s cost savings actions and working capital improvements.
However, from that lower base, it’s hard to imagine such a significant step-up in industrial cash flow in 2018 that the dividend is nicely covered while giving GE the ability to invest in strategic areas, pay for its restructuring activities, and improve its balance sheet.
Flannery announced that he expects to divest $20 billion worth of assets over the next 1-2 years, which provides cash but further reduces ongoing earnings streams from which to fund the dividend.
It’s also worth pointing out that GE ended the quarter with only $8 billion of cash on the balance sheet (excluding Baker Hughes-GE cash). Given the industrial cash flow deficit, meaningful cash restructuring costs ahead of the company, and some uncertainty about when the next GE Capital dividend will be paid, reducing the common stock dividend would provide some relief.
Management’s actions also seem to support this stance. Flannery emphasized that total shareholder return is a focus (i.e. ownership of GE stock is about more than just the dividend) and that the company’s capital allocation needs to be balance between investing for growth and the dividend payout.
GE’s slide presentation made no mention of supporting the dividend’s current level either, and management would have presumably been much more vocal on the call of backing the dividend if there was any legitimate desire by the new leadership team to support it.
In a perfect world, GE would have been able to continue paying its current dividend while making the tough decisions to improve its culture, take out substantial costs, reduce business complexity, focus more on its attractive industrial segments, and ultimately free up more cash flow.
However, a combination of mismanagement, depressed power generation and energy markets, and a new leadership team with a different set of capital allocation priorities has seemingly eliminated that script.
The actions management will reveal next month will likely be in the best interest of long-term shareholders, and I think the company continues to have a set of attractive, durable businesses.
However, with new management putting the dividend fully on the chopping block, the General Electric is no longer of much interest for investors in need of higher-yielding stocks that can deliver safe and growing income.
The Importance of Portfolio Diversification
I’ve held shares of General Electric since July 2015, recording an unrealized total return of approximately -7% while the S&P 500 has gone on to return about 30%. Saying I am disappointed with this performance would be an understatement.
While I am often guilty of beating myself up over any single holding that doesn’t perform as I initially hoped, every dog (and there will certainly be more) serves as a reminder of why I maintain a diversified portfolio.
Simply put, healthy diversification prevents any one stock from blowing up a portfolio’s total returns and income generation.
While General Electric’s performance has floundered since I initiated my position, a number of our holdings are tracking with their investment theses and delivering very healthy total returns.
Boeing (BA), McDonald’s (MCD), Waste Management (WM), General Motors (GM), and Consolidated Edison (ED) have returned approximately 92%, 84%, 71%, 65%, and 56%, respectively, since inception, for example.
Thanks to spreading our bets across different dividend growth stocks and holding more winners than losers, our two portfolios holding shares of General Electric have continued recording healthy returns.
The total returns seen below are from inception in June 2015 through October 20, 2017.
Despite GE’s continued slump, our Top 20 Dividend Stocks and Conservative Retirees portfolios have returned between 2% and 4% thus far in October, and their returns since inception remain on solid ground, both on an absolute and relative basis.
The portfolios’ returns have also recorded less volatility than the broader market’s, in line with one of our objective to better preserve capital over time.
Equally important for conservative dividend investors is the income stream a portfolio generates. The charts below show the dividends receivable on a quarterly basis for our Top 20 Dividend Stocks and Conservative Retirees portfolios, as well as relevant dividend ETFs.
You can see that each portfolio has recorded not only higher dividend income and healthy payout growth since inception, but also much less income volatility.
Despite weak dividend growth from GE over the course of our holding period, our Top 20 Dividend Stocks and Conservative Retirees portfolios have recorded 12.4% and 6.4% dividend growth over the trailing 12-month period.
GE’s last announced quarterly dividend will be paid in full this Friday, and the next task will be replacing the income stream from this holding with a company that is better positioned to deliver safe, growing income.
While studies have shown that losses hurt twice as much as gains, it’s important to keep things in perspective. I’ve felt the pain from GE since I personally hold stakes in all of the companies in our portfolios, but I’ve also benefited from the capital appreciation and dividend growth recorded by most of our other holdings.
Investing is largely a numbers game, and I know that odds are close to 40% or even 50% of my holdings will go on to be underperformers.
However, by sizing my positions responsibly, letting my winners ride, and doing some pruning only when necessary, I like my chances of continuing to generate healthy total returns, relatively low volatility, and a generous dividend income stream that remains secure and growing each year.
Here are the guidelines I like to follow to stay diversified and help steady the value of my portfolio and its income stream:
- Hold between 20 and 60 stocks to reduce diversifiable risk
- Equal-weight each position because it’s hard to know which companies will be the best long-term performers
- Invest no more than 25% of your portfolio in any one sector
- Target companies that score close to 60 or above for Dividend Safety
Closing Thoughts on General Electric
General Electric’s latest earnings report and management commentary make it clear that the stock is no longer appropriate for portfolios seeking safe, growing dividend income.
I expect management to announce a cut the company’s dividend, probably between 25% and 50%, when CEO Flannery gives his presentation on November 13. How investors will react to this news, along with Flannery’s 2018 guidance and long-term plans for the company, is anyone’s guess.
Reducing the dividend is arguably now in the company’s best long-term interest as it looks to improve its cash flow, cut costs, divest non-strategic business lines, shore up its balance sheet, and maintain the financial flexibility it needs to drive sustainable earnings growth over the next five years and beyond.
I do think GE’s stock looks interesting for enterprising investors who are focused on long-term total returns and less worried about dividend income volatility.
While healthy total returns are one of our portfolios’ objectives, it’s time to move on to another company that is better positioned to not only provide moderate capital appreciation and relatively low volatility, but also highly secure and rising dividend income.