The year 2013 has been characterized by stock prices hitting all-time highs throughout the year. As a result, many dividend investors hold shares of quality companies where rising prices have pushed yields below their minimum yield criteria. The question on the minds of most investors is whether it would make sense to sell these companies, and purchase shares of other quality dividend stocks that have higher yields.
Let’s walk through the example of selling a company that grows dividends at a high rate, but currently yields 2%. That could be Becton Dickinson (BDX) or Colgate Palmolive (CL). For the sake of walking through the example, let’s assume that the funds will be invested in Consolidated Edison (ED), which is a higher yielding electric utility.
When a dividend investor sells their shares at a gain, they have to pay taxes on the profit. Depending on the length of time the shares were held for, the gain could be taxed as ordinary income or at more preferential capital gains taxes. Either way, when you sell appreciated stock and pay taxes, you are left with a lower amount of capital to reinvest.
The other factor to take into account is not only the current yield, but realistic growth projections as well. If you sell a perfectly good quality company that you are well familiar with, simply because current yields are a little low, and you purchase shares in a company which might or might not perform as well as the first company, you just create reinvestment risk.
If you sell Becton Dickinson that yields 2%, and buy Consolidated Edison that yields twice as much, you double your current yield and dividend income. However, you will be missing out on future dividend growth, and thus your dividend income might lose purchasing power over time. Over the past five years, Becton Dickinson has grown dividends by 13.50% per year, while Con Edison has boosted them by about 1% per annum.
If Becton Dickinson increases dividends by 10% per year for the next 14 years however, a $1000 investment in the stock today could generate $80 in annual dividend income. With Con Edison, a $1000 investment today will likely generate less than $50 in annual dividend income. The caveat is that future growth is uncertain however, but so is the sustainability of high current yields.
The next factor you have to take into account is your investment horizon. Your investment timeframe should be 20-30 years. Even if you are 60-70 years old today, you might still have to plan for a 20-30 years of retirement. You don’t want to chase yields today by buying stocks solely based off yield. These might not maintain purchasing power or might offer a higher risk of a dividend cut or freeze. This would downgrade your standard of living in the last part of your retirement, when you are less likely to be able to cover the shortfall by finding and holding a job.
Even if you sold Becton Dickinson and bought something else like Chevron (CVX), you are still taking a reinvestment risk. The risk is that in 10-15 years, the amount of dividends that Becton Dickinson’s will pay will be higher than the dividends that Chevron will pay. This could happen if Becton Dickinson increases dividends faster than Chevron during that time period. Further, if oil prices fall in 5 years, Chevron might not even increase dividends at all.
Your goal is to avoid situations where you are essentially compounding mistakes. When all is set and done in 20 years, do you think you would be better off doing nothing or selling and buying something else? If you sold a perfectly good dividend grower, that grew earnings and dividends like clockwork, you paid a tax on gains. This provided you with less money to invest than in the first place. You then purchased shares in a company where you don’t know if the dividend income from this position would be higher or lower than the dividend income from the original position in 20 – 30 years.