With the market hitting fresh month highs, investors have to look hard in order to find attractively valued opportunities. Plenty of stocks such as Aflac (NYSE:AFL), Emerson Electric (NYSE:EMR), 3M (NYSE:MMM) and Realty Income (NYSE:O), which in early 2009 rewarded enterprising dividend investors with their highest yields in a decade, are now yielding much less. Many stocks are also trading at rich valuations, which suggests that investors these days are willing to pay a premium for future growth.
The rapid increase in prices since March 2009 lows has many dividend investors wondering whether they should lock in some or all of their gains today. Investors who were able to purchase stocks in 2008 and 2009 might be sitting at gains, which seem equal to the dividend payments they could expect from a stock for several years to come. The issue with this thinking is that dividends typically increase over time on average while cash in the bank typically loses its purchasing power over time. As a result the investor who takes profits today might lose on any increases in dividends as well as on any future price gains. They would also have to find a decent vehicle to park their cash, which is getting harder and harder to find these days.
Because of the reasons stated above I would not consider selling even if my position went up 1000%. It would not be a wise idea to sell a stock which was purchased as a long-term holding and its business hasn't changed much. What is important is that the original yield on cost that has been locked with the purchase in 2008 or 2009 is there to stay, as long as the dividend is at least maintained. I would only consider selling when the dividend is cut. If a stock you purchased had a current yield of 8%, your yield on cost is 8%. The nice part about this is that you keep receiving 8% on your original cost as long as the dividend is maintained. Then it doesn't really matter if the stock is currently yielding 1% or 2% - you still earn 8% on your cost. If the dividend payment is increased, then your yield on cost rises as well. Companies like Johnson & Johnson (NYSE:JNJ) or McDonald's (NYSE:MCD) for example have low current yields of 3%, but their growing dividend payments produce substantial yields on cost over time.
If you were thinking of selling a stock which generates great yield on cost, you should remember that currently the market is overvalued. But the market could keep getting overvalued for a far longer period than you or I could remain sane. Retirees need income, and in the current low interest environment dividend stocks seem to be the perfect vehicle for an inflation adjusted source of income in retirement.
Back in the late 1980s Procter & Gamble (NYSE:PG) yielded less than 3% for the first time in decades, which was much lower than the 4% average yield that investors received in the mid 1980s. In early 1991 the stock traded at $10.50, yielded 2.40%, and paid 6.25 cents/quarter. Although bonds yielded at least three times what P&G yielded at the time, they couldn't provide rising income payments and the possibility for high capital gains as well. By early 1994 Procter & Gamble stock increased to $14, after a 2 to 1 stock split, paid 8.25 cents/quarter and yielded 2.20%. In early 1999 Procter & Gamble traded at $46.50 and had split 2:1 in 1997. The company paid out 14.25 cents/share but yielded only 1.30%. The yield on cost for the early 1991 investor was a more comfortable 5.50%. Fast forward to 2010 and Procter & Gamble is trading close to $64 and yielding 2.80%. The yield on cost on the original 1991 purchase is 16.80%. This example goes on to show that selling Procter & Gamble when it became overvalued, was not a very good idea, because the company kept generating higher earnings and kept increasing its dividend payment. While investors could have found other stocks to reinvest Procter & Gamble dividends or allocate any new cash, they would have been well off simply holding on to Procter & Gamble and other dividend raisers despite them being overvalued for extended periods of time.
Right now, Procter & Gamble looks like it yields about 3% but is fully valued at 20 times forward earnings. The company might be a very good candidate for addition to my existing position if the market dips further from here.
Disclosure: I am long ABT, AFL, EMR, JNJ, MMM, O, PG, MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.