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A few months ago, Robert Allan Schwartz published an article on SA titled, "How To Raise Portfolio Income By Selling Overvalued Companies." This was an excellent article and it forced me to consider a weakness of mine as an investor; when do you sell an investment? In this article I want to share my thought process of what I believe a selling decision should be based on and a real world example of how such a strategy is executed. I'm not making recommendations to sell or hold; merely sharing my attempt at clarifying such a decision.

Among the Dividend & Income crowd here at SA, much is written on the buy side of investing. You will find countless articles recommending dividend stocks and various ways in which the DGI strategy can be utilized. I am thankful for these contributions as they have helped me advance my thinking when it comes to investing. However, there appears to be room for more discussion on the sell side of the equation. Selling tends to get a bad rap and for good reason in most circumstances. A sell order comes with a commission as well as capital gains taxes (if you're lucky and a loss of capital if you're not).

Complicating the issue even more is the association of selling being under the domain of traders. The DGI community, of which I am a member, tends to prefer a buy and hold/monitor approach over a buy/sell approach. Please don't mistake what I'm attempting to express here. I do believe DGI proponents have reasons for selling, but these reasons tend to focus on "negative" events, such as a company cutting its dividend, not growing the dividend or other similar event. What I'm curious about is if/when a sell can be initiated to enhance the overall portfolio, a "positive" reason for selling.

As Robert pointed out, there really is no reason to sell due to capital appreciation alone. If this were the case then selling would be a very subjective decision. When to sell would be more a matter of where the investor places value along the line of capital appreciation. It could be 10%, 20%, 50%, 125%, or X%. I want to try to stay away from this subjectivity and ground the decision-making process in something more objective. For me that objectivity can be found in the overall investors goal(s).

Granted this too has a bit of subjectivity due to each investor having slightly different goals. However, in the DGI community I believe many of our goals are similar. I'm going to outline mine here so we have something to use as a reference and make this case study much more relevant. Below you will find what I'm trying to achieve with my investment activity:

  1. Preservation of capital.

  2. A total return in each investment that matches current inflation plus a 5.5% risk premium.

  3. An increasing income YOY.

Keep in mind that these are the bare minimum outcomes I'm willing to accept. Now that we have an end point in mind for our activity, I pose the following question:

Will selling a particular stock bring about an enhanced outcome for the overall goals of the portfolio with the same amount or less risk as opposed to holding the stock for a longer duration?

I'm trying to remove my focus away from how much price appreciation in a stock is needed as well as the concerns of the difficulty in assessing overvaluation in stock price appreciation, as was mentioned in the comment section of Robert's article. These are valid concerns, but ones I'm not sure our decision making process should be based on, merely considerations.

What follows is a case study in how this might work. Keep in mind that any human thought activity aimed at predicting something as uncertain as price movement and stock performance is surely to be an "educated" guess at best.

Case Study

Theory is great, but we really need solid examples of how theory might work in practice. I'm going to list here an actual example from my own portfolio and use the criteria listed above to see if I can come to answer as to sell or not.

I purchased AT&T (NYSE:T) in two lots in the early part of 2011. Listed below is the number of shares purchased and the price paid:

200 @ $28.46

100 @ $29.88

Total capital deployed was 8680. I recently sold AT&T at $338.25 giving me a market value of 11,475. In addition to this I've received $697.00 in dividend payments. Again, I'm not focusing on the dollar amounts of appreciation. I'm merely trying to give some background information on why AT&T might be a good sell candidate. Taking a 40% gain qualifies in my book especially if I can potentially redeploy the capital into a stock that is at the other end of its price cycle.

By my calculations I have just over five years of dividends in capital appreciation at this moment. As Robert points out in his article, by selling AT&T, I harvested those future dividends. The question is could the initial capital and capital appreciation that has been harvested from the sell be utilized to bring about a greater return for the portfolio?

Going back to the comment section of Robert's article I find two valid objections to this strategy. The first one is determining overvaluation and the second, and arguably the most important, is picking replacements. This is a legitimate objection as there are only a few ways of getting it right and many ways of getting it wrong. I think the consideration needs to be given to finding fair value or undervalued stocks for our replacement companies. If this is done, the performance will be there. This is by no means an easy undertaking.

The Replacements

Finding a stock(s) to replace one that has performed well is not easy. An argument could be made for settling for good enough. One good stock in the portfolio is worth more than two potentially good stocks in the market right? I would not disagree with this sentiment. However, I do believe that one can increase a portfolios value by trading opportunistically and by that I mean taking advantage of market inefficiencies.

Markets are suppose to be efficient and most of the time I believe they are. However, as with any system, there will always be some inefficiency. Take a system that is made up of various institutional and retail investors making decisions based on numerous variables and you have the potential for a great amount of inefficiency to exist at times. Buying opportunities present themselves frequently due to market participants overreacting or under reacting to information. It is looking for these inefficiencies and attempting to take advantage of them that I have selected my replacements.

The following are companies I feel represented good entry prices at the time and will allow me to achieve my investment goals outlined earlier. Below are the two stocks I purchased with the sale of AT&T (T):

  • Intel (NASDAQ:INTC)

  • Norfolk Southern Company (NYSE:NSC)

Neither Intel nor Norfolk Southern fared well after their earning forecast adjustments. There was a drop when the warnings were given and another one when earnings were actually reported. I don't dispute that both companies face short-term challenges, but short-term challenges don't worry me. I believe that the price drops offer buying opportunities for long-term investors. This article is not meant to be an analysis of the above-mentioned companies. You can find plenty of those on SA as well; my goal is to share my attempt at optimizing my portfolio by selling high and buying low. Let's continue to look at what I have done towards that end.

Finding Suitable Replacements

Engaging in this type of investing activity is not without risk. As I stated above, one of the inherent risks is deciding what to replace the winning strategy with. If you have sold at a gain, then your initial stock selection was successful, but when you sell you are now faced with trying to pick another winning strategy and that is not always as cut and dry as it seems. When you are considering replacements, you are always faced with a series of questions. DividendGrowthMachine shares some of those questions from his comment on Robert's article:

Can a suitable replacement stock be found that restores (ideally increases) the lost income stream? Is that stock available at an attractive valuation? Are the new company's prospects, both in terms of its business and the stock's total return, more attractive than the old company's prospects?

In my opinion, this is the greatest risk an investor takes; investing realized gains into anticipated gains. This is what I have done with my selection of Intel and Norfolk. The crystal ball is still cloudy, the investment thesis untested. Below is the purchase details of those two investment along with how it compares to the position I sold in AT&T.

I entered into Intel with two separate purchases giving me an average share price of $20.83 and a YOC of 4.3%. I did the same with Norfolk, entering with two separate purchases giving me an average share price of $60.94 and YOC of 3.28%. Total income from these two stocks comes out to be $435.00 vs. $540.00 for AT&T or a 19% reduction. The question still remains: am I better off? Would I have done better just holding on to AT&T and doing nothing? To answer this question with any certainty will require time. I will venture to say what I hope will happen and why I think the trade will be successful.

I now have two stocks in my portfolio where as before I had one. If you are strong proponent of diversity this is a good thing. I generally hold a concentrated portfolio so this is a weaker supporting argument for me. However, I do believe that having two quality companies in separate sectors will increase exposure to growth in those sectors and reduce the risk associated with holding too few stocks.

I now have a better prospect for dividend growth. AT&T had a high yield, but not a very high dividend growth rate. My portfolio already has a few slow or stagnant performing dividend yields, having a couple of growing dividend stocks should be beneficial. My hope is that they will soon match or surpass what I was earning from AT&T.

The potential for price appreciation is high on my wish list as well. Total return is still very important to me and you need both strong yields and price appreciation to generate a solid total return. I think the price that I entered into both NSC and INTC are fair and leave room for price appreciation to take place. If all these factors work out the way I hope, then I have indeed optimized my portfolios performance.

I'm looking forward to hearing what you guys think about this approach. I hope to hear both those in agreement and the dissenting voices. It takes both to fully understand a subject.

Source: Optimizing Returns By Selling Overvalued Companies