by Dividend Growth Investor | January 6, 2014 9:00 am
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.
The next factor to think about is that replacing appreciated shares simply because the yield is low, for a higher yielding security, should take into account past and projected growth in earnings and dividends. An investor should look for growth at reasonable prices, and should not focus solely on the dividend income at all costs, while ignoring capital gains. This is because a company that cannot grow earnings and dividends today, will likely be unable to grow share prices over time. This is important, because your capital is losing purchasing power over time.
In contrast, a company like Becton Dickinson has a growth kick that can result in growing earnings and dividends, which could eventually translate into higher prices. Most equities share a portion of earnings with shareholders in the form of dividends, and then reinvest the rest, in order to grow and maintain the business. A company like Con Edison, which pays out a very high portion of income to shareholders will be unable to grow quickly enough. As a result, its earnings power might not translate into growth in dividends and stock prices, that can maintain purchasing power of your income and capital.
The next factor is that chasing yield for sake of yield is a very very dangerous thing. Most investors who start investing for dividends always seem to be attracted to the highest yielding securities out there. This is a mistake, because they are usually not taking into consideration the sustainability of the dividend payment. Most of these investors do not do a very good homework in understanding the business model of a high yielding company, and are focusing only on the high yield aspect of it. What good is a 16% annual dividend yield, if the dividend payment is cut by 80 or 90% in the next year?
You would have been better off with a company yielding 2 – 3% in the first place, that has the capability and desire grows dividends over time. The issue with selling an appreciated company that still has potential, for a higher yielding one, is a slippery slope in yield chasing. Once you sell start selling the lowest yielding components of your stock portfolio, without accounting for such factors as sustainability, growth, and understanding of the business, you are becoming essentially a yield chasing investor. In reality, yield should be the last factor in your fundamental analysis.
The last factor on selling is mostly a blend between my personal experiences as a dividend investor and academic studies on the performance of individual investors. According to academic studies, individual investors routinely underperform their benchmarks by as much as 9% per year. This is caused by frequent trading in their portfolios. Based on my own experiences, I can vouch to these findings 100%. When I look at some of the sales I have done, most of them have been pretty disastrous. I have essentially managed to sell a stake in a company that was growing well, and might have looked overvalued relative to another company.
However, after a few years, I calculate that I would have been better off simply holding on to the original security, without the hassle of extra taxes, paperwork, commissions and strains on my already filled schedule. When I sell I am usually worse off. I have realized that I would have been better off just doing nothing, and not tinkering with my portfolio. The point is when you reach out for yield you are sacrificing growth potential and altering the risk profile of your portfolio. You should be aware of that, and be ok to accept lower growth and capital gains that could bring more dividend dollars in the future, for the higher immediate dividend income that will produce less in future dividends and capital gains.
All of this doesn’t mean you should never sell a stock. If it is really overvalued, cuts dividends, or if something material changes, you might be better off selling and going someplace else. However, you need to think about some of the factors explained in this article, in your decision making process on selling.
The urge to do something is the thing that will cost you in the long run. If fundamentals are fine, there is decent EPS growth, DPS growth and you still expect it to continue, your job is to sit tight on investment and let the company do the compounding for you. Sitting is the toughest part of investing, especially in an era where you are bombarded with information on investments all the time. Sitting on an investment, and holding for the long term, might after all be the best strategy for ordinary investors.
Full Disclosure: Long BDX, CL, ED, CVX
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