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Long-term horizon, dividend growth investing
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I would like to start off by saying that I'm a dividend growth investor at heart. No, dividends are not guaranteed to flow but when a company has paid increasing dividends for longer than I've been alive that should count for something. Those companies all started growing their dividends at some point so if you can purchase shares of a new, rising dividend star then you have the beginnings of a potentially life long, profitable position. But what happens when one of those new, up-and-coming companies in your portfolio suddenly takes off on a bull run?

The Problem

As an investor in their accumulation phase, I happily bought a small initial position in just such a company: Gamestop (NYSE:GME). When I made my purchase, shares were about $20.03 each with a yield of 5%. The company had no debt! I believed in their business model. The company initiated a dividend and then hiked the rate by 66% before paying their second dividend! What could go wrong?

Flash forward to today, just seven months later, and the share price is up 50% over my cost basis. The yield is "only" 3.6%. Their first ever dividend was $.15 per quarter, paid Feb 12, 2012. Their most recent dividend was $.275 per quarter, paid March 1, 2013. They have paid four dividends and increased the amount paid three times. That's great news but what about that 50% paper gain? It starts to look real tempting, tempting enough to be a problem.

I have thought my only hard and fast rule about selling a position in a dividend growth portfolio is "sell a company when it fails to raise its dividend annually." But now I'm faced with a position being too successful. Dividend growth portfolios are supposed to be slow and steady things, right? Just because a position outperforms expectations does not mean there is really a problem. However, this portfolio is designed to grow dividends. So the real question is can I convert those paper gains into dividends?

A Mathematical Perspective

I soon realized that the best way to compare my paper gains versus dividends was a mathematic model. To construct a model we must first make some basic assumptions about a starting point and growth. Assume that we are considering a $1,000 initial position, $20 initial share price, 5.0% yield. To model the current problem, in 2013 we bump the share price up to $30 and use 10% annual growth rate for both share price and dividend. The model will also reinvest all dividends.

PriceSharesDivAnnual DivsDiv Lost
2012$20.0050.00$1.00$50.00
2013$30.0052.50$1.10$57.75$57.75
2014$33.0054.43$1.21$65.85$123.60
2015$36.3056.42$1.33$75.10$198.70
2016$39.9358.49$1.46$85.63$284.33
2017$43.9260.63$1.61$97.65$381.99
2018$48.3262.68$1.77$111.36$493.34
2019$53.1565.16$1.95$126.98$620.32
2020$58.4667.55$2.14$144.80$765.13

So the question is, do we sell today for a $500 gain or hold and collect dividends? From the table above it is clear that the "break-even" point, where today's gains are matched by tomorrow's dividends, happens at the very start of 2019. Given the model, selling today is seven years' worth of dividends! That sounds like a good deal to me.

Not to mention that we can take the entire $1,500 profits of the sale and redeploy them into a different stock. We only need to find a stock yielding 3.6% to match the income lost from selling the GME position. Even though yields have come down thanks to our overall market rally there are still plenty of names to be had with 3.6% yield. In the same dividend growth portfolio I hold six companies that are above a 3.6% yield:

  • Altria (NYSE:MO) at 5.0%
  • ConocoPhillips (NYSE:COP) at 4.5%
  • Intel (NASDAQ:INTC) at 4.3%
  • Darden Inc (NYSE:DRI) at 4.0%
  • Waste Management (NYSE:WM) at 3.8%
  • Hasbro (NASDAQ:HAS) at 3.7%.

Investing the $1,500 in any of those companies will actually provide a higher income than sticking with GME for the time being.

Of course there are several things to consider before selling a dividend growth position like GME. First and foremost, the model could be wrong. If GME grew their dividend at 20% annually, instead of the 10% we assumed, then our break-even point would happen in 2017. Selling today would "only" yield five years' worth of dividends. Secondly, what if GME's share price tanked? The dividends would buy more shares at the lower price, potentially decreasing that break-even point. I won't post another chart but using the same computations and changing our assumptions to a 2013 share price of $22 and a dividend growth rate of 20% we still have to wait until 2017 to hit our break-even!

Summary

After constructing a model and seeing the length of the break-even point I sold my position in GME. I never purchased it expecting to make a 50% return in seven months but that is a problem I wish I had more often. Regardless of what the break-even point may be there is still the problem that by selling out of a dividend growth position you are forsaking future distributions. However, after seeing how many names I already own that could increase the portfolio's income I felt much more comfortable selling out of GME and redeploying the capital elsewhere.

This portfolio is part of my Roth IRA so all of the events described are tax free so taxes were not part of my consideration. Furthermore, given the length of time before I can draw on the Roth I would rather have the extra capital now to enhance the portfolio's income and let compounding interest do its thing. I have certainly heard of investors rebalancing a dividend growth portfolio but I have never heard of a recommendation to completely liquidate a position because of price appreciation. I am certainly not advocating that in all cases of paper gains but considering the model presented in this article I would recommend giving it some consideration in the right conditions. As I have stated, none of the profits made were taxable and my time frame allows for converting the additional capital into a divided stream. Producing a growing income stream is the basis of dividend growth investing and I certainly recommend investors make use of all resources to accomplish this goal.

Source: When To Take Profits Over Dividends