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Dividend Stocks: When Should You Sell Them?

August 13, 2012
Holly LaFon

Stockopedia

1 followers
“Buy low and sell high” is the mantra of a lot of investors, but is less often adhered to by dividend investors who tend to subscribe to a "buy and hold" philosophy. They tend to be more comfortable holding onto their investments even as they soar in value because the focus is on the income, not the share price.

Indeed, some hardcore dividend growth investors, such as David van Knapp argue that you shouldn't need to sell dividend stocks ever!

Why is that? van Knapp makes an interesting point is that:

"under conventional retirement planning, one accumulates assets during his or her working years, then begins selling assets upon retirement to provide "synthetic" income, meaning that it is not generated naturally by the investments themselves".
The rate at which an investor sells down assets is then determined by things like the 4% Rule, a rule of thumb (created in 1990s by Bill Bengen, a financial adviser) which argued that, if you spend 4% of your capital in your first year of retirement, you can go on spending that much until you die.

Unfortunately, as many people have found out, this kind of thinking makes dubious assumptions about longevity and market returns, which are increasingly questionable due to uncertainties over inflation rates, stock market downturns and health care bills.

Instead, van Knapp suggests that the better approach is to sell nothing at all, ideally. Instead, the dividend income generated naturally by the assets should be all that is removed from the investment account (although that actually still has the same issue of matching certain cashflows to uncertain liabilities). On this view, price falls (or even a bad economy) should pose no particular threat, because there is little correlation between dividends and stock prices.

While a "Buy-And-Hold" approach to dividend investing may have some merit, it's worth stressing that this does not excuse "Buy-And-Forget" – a better approach is likely to be “Buy, Hold amp; Monitor”. Dividend investors need to keep a close watch on their investments to ensure that their dividend income stream remains intact. Things may change in an uncertain world and adjustments must be made from time to time. Purist "Buy and hold" also isn't really practical if you have pressing amp; unexpected liquidity needs that exceed your current/planned income.

With that in mind, here is a "sell signal" checklist of four key questions that every dividend investor should be considering with respect to their portfolio:

Question 1: Has there been a Dividend Cut?

If a company reduces or eliminates its dividend, then this may be an appropriate time to sell for a dividend investor. This is not just because of the loss of the long-term passive income stream but also because the market response to such cuts tends to be indiscriminate. Several studies have shown that investors simply dump the stock – in 80 percent or more of cases, the stock prices of firms that cut dividends drops sharply, at the time of the announcement. Furthermore, research by Michaely, Thaler and Womack found that that stock prices then continue to drift downwards in the weeks after a dividend decrease. And this seems to happen no matter what the stated reasons for the dividend cut.

While some commentators may present this as a hard and fast sell rule, it's still worth being circumspect. Firstly, you might be selling out at the bottom and, secondly, as we've discussed elsewhere, a dividend cut is not always bad news from a medium-term perspective. Companies may cut or suspend dividends for several reasons; some clearly have negative implications for the future prospects, whereas others have more positive implications. It may be: a) A last ditch response to operating problems (declining earnings and losses), i.e. the company has finally run out of other options (very bad news), b) a pre-emptive action to increase financial flexibility and avoid future problems e.g. by using the cash saved to retire debt (moderately bad news), or c) it could simply be because the firm wants to invest more than it expected, e.g. a dramatic improvement in its strategic options (potentially very good news for its long-term prospects).

While sometimes the cancelled payout is a sign that the company is toast, in other cases, the action may be in the shareholders’ long-term interests. A company may be taking prudent measures to conserve cash in tough times or it could be a wise decision to divert cash to exciting new projects. Of course, scepticism towards a dividend cut is understandable but the data suggests that the market tends to be overly-sceptical. So, if you’re still a shareholder in a company that decides to scrap its dividend, it may not make sense to sell the stock straightaway. Each individual case should be taken on its own merits. There looks to be value to examining closely timed earnings and dividend cut announcements to see if the market reaction is justified.

Question 2: Has there been a Fundamental Change?

If a company changes dramatically, it's worth reviewing its usefulness as an investment to you. It's always worth writing down at the time of purchase the specific thesis that underlies the investment and any metrics for tracking this. This allow you to monitor how future events have impacted that thesis objectively, without getting caught up by hindsight bias or issues of loyalty or saving face. Using this, it's very good practice to periodically review your investments and ensure that you still own them for logical reasons.

Examples of major changes that may undermine your reasons for investing in that company include a change in strategy, a huge macro-economic shift, or a spike in leverage. In the case of Mamp;A, frequently, such deals are made with a lot of cash — meaning there may be less to pay out in dividends. Alternatively, you might find that a company with a great yield and good potential for shares has been bought by a stingier or less favorable competitor. It may be better to dumpt of the position instead of accepting the resulting shares from the buyout. Another example of fundamental change could be the oil disaster in the Gulf for BP. The company was just not prepared for a situation like it faced and, as the damage claims mounted, investors lost confidence in management to resolve the issue, leading to a sell-off and a dividend cut.

Question 3: Is the Stock severely overpriced?

As we've discussed, dividend investors are mostly focused on the dividend income rather than the stock price. However, there are some circumstances where even the most hardened income investors might be cautious, namely where the stock has become so overpriced that you’re unlikely to earn a Total Return, even factoring in the Dividends, because there is material amp; significant risk to the share price. This may be because the share price has soared well beyond your estimate of intrinsic value. An alternative way to spot such a scenario is where the dividend yield has declined to historic lows. This was the approach used by a range-trading dividend investor like Geraldine Weiss, the time to sell was when the dividend yield declined to historic lows. This suggest that it's likely that the stock will "mean-revert", potentially leading to a significant loss of capital.

Question 4: Is the Stock down by over 50% since purchase?

Jeff Reeves of InvestorPlace.com suggests another circumstance where dividend investor should maybe look towards the exit. He notes that, while fluctuations in share price are not necessarily a problem for dividend investors, watching a position decline by over half should set off warning bells. His rationale:

"A dividend stock with a yield of about 2% will take 50 years to “double your money” via dividends... Waiting five decades (if not reinvested) just to get back to square one doesn’t make any sense no matter how healthy the dividend payout is".
Sometimes you may be better off taking the loss and moving on to greener pastures, rather than relying on a price recovery that may never come.

Conclusion

Managing your portfolio and knowing when to sell stocks is one of the most difficult aspects of investing. You need to to be vigilant and keep a close watch. Even as a Dividend Investor, It's important to put in place a plan, rather than risk being swayed by fear of loss or regret.

If the price of a stock falls dramatically in a short period, it's important to keep a cool head and remember the reasons why you invested in the first place. It may be that the market is fleeing the stock because of serious underlying troubles - and, if one of the above three criteria apply, you may want to sell up and live to fight another day elsewhere.

However, it's also important to understand your opportunity cost vs. other investments, remembering that dividends typically increase, while cash in the bank may just lose its purchasing power over time.

If the fundamentals of the business remain solid, a price fall might even be an opportunity to average down your cost basis by buying more shares!


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