This is a great question from an older investor named Carol that should resonate with many readers:
“I am a retired senior investing in dividend stocks that I live on. At this point, there are some of my dividend stocks that have increased over 30%. My gut feeling is to take the capital gains, but then what do I do? Do I sell the appreciated stock and wait until a pull back to buy them back and just do without the dividend for a quarter or so, or do I only sell only half of the investment? Do I try and find another good dividend paying company to replace the one I sold?”
Younger investors or well-heeled traders may not realize that living off your dividends as income is a common way to provide for retirement. But I know from real-life exchanges that this is very much the situation that many investors are in right now.
Stick to Your Dividend Strategy
Carol’s situation is enviable, in that she has enough cash to live on and her stocks are performing well. But for someone like this, share appreciation wasn’t the original goal. It’s simply a nice byproduct.
So my first morsel of advice is simple and philosophical: Don’t doubt yourself, and don’t change a strategy that is working just because of the lure of bigger dollar signs.
Too many buy-and-hold investors panicked and tried to be short-term traders in 2009. Too many low-risk investors were captivated by the glitz of the Facebook (NASDAQ:FB) IPO and took it on the chin. And of course, many dividend investors have been sucked in to the trap of chasing yield.
If there’s not a compelling need for this capital such as medical bills or a compelling tax reason to close out positions, don’t overthink it. Stick to your strategy if it’s working and don’t get distracted.
Study after study shows investors trade too much and hurt themselves. If your investments are working you have no reason to change gears.
That is not to say I advise doing nothing, of course. There are a few stress tests I think are appropriate for all income-oriented investors — whether they are sitting on big capital gains or small capital losses.
Yield On Cost
A very important metric when considering whether to sell a dividend stock is your “yield on cost.”
The annual dividend yield you see on finance websites is based on today’s pricing and payouts using the equation of (last dividend amount x four quarters) / current price. That’s useful to a new investor buying at that pricing, but not long-time investors. After all, you bought the stock at a previous price – not today’s price.
So to get your yield on cost you should use the equation (last dividend x four quarters) / purchase price. It sounds academic, but it’s actually quite an important distinction.
Take General Electric (NYSE:GE). If you bought in 2003 at $29 a share and a 19 cent quarterly dividend, you’d have a yield of about 2.6% at the time of purchase. If you’re doing the math, that’s $0.76 annually divided by $29.
GE has had a volatile run in the intervening years, and now the stock stands at $21 a share paying 17 cents a quarter for a current annualized yield of 3.2%.
But forget about both of those numbers. What really matters is your yield on cost. And you paid $29 a share. With a current dividend of 17 cents, your actual yield on cost is 2.3% annually. Not looking so attractive as an income investment, now, is it?
It cuts both ways, too. A stock that appears to be soaring may not actually pay you any more in dividends. That’s the case with utility Consolidated Edison (NYSE:ED). ConEd is up 45% in the last five years — great share appreciation. But its dividend moved from 58 cents a quarter in 2007 to 61 cents now. Your yield on cost remains largely unchanged.
The Case for Holding to High-Flying Dividend Stocks
Now let me use the example of a high-flying stock like the ones Carol may have in her portfolio to show you how hanging on may be the smartest thing you can do.
Let’s say you bought McDonald’s (NYSE:MCD) at $18 a share in 2002. It was paying dividends of 23.5 annually for a yield of 1.3%. Now the stock is up 280% in your portfolio! You may want to take profits, right?
Wrong. Because as a dividend investor you may never find a bigger payday than MCD at your cost basis. You see, McDonald’s is now paying 70 cents a quarter in dividends for $2.80 annually! That’s a mammoth 15.5% yield on your cost basis.
Do you think you can get a better income generator on Wall Street than that?
Even if McDonald’s stock declines 30%, as long as the dividends remain constant you are getting a huge payday. So if your primary goal is to generate big dividends, then selling your 15.5% cash cow would be a giant mistake.
Dividend Payout Ratio
How can you ensure that those dividends you’re receiving are sustainable, though? Well just look at the dividend payout. It’s a simple calculation of taking the annual dividends divided by the earnings per share.
Let’s take dividend stalwart Procter & Gamble (NYSE:PG) is paying 56 cents per quarter or $2.24 per share annually. It is estimated that PG will earn $3.90 in earnings per share for the current fiscal year. Thus, it is paying 57% of profits back to shareholders in the form of dividends.
Historically, 50% is about right for major corporations. Obviously, if you’re pushing 80% or 90% of profits as dividend payments, you run the risk of a dividend cut if earnings take a tumble. A little cushion is necessary for sustainable payments.
Also, a lower rate of around 30% or less may signal the potential for bigger dividend increases going forward. Even if profits flatline, the company can comfortably increase payments.
Got a question on investing? Write me at email@example.com.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.