Some investors believe that holding overvalued dividend stocks represents a lost opportunity cost. However, an overvalued dividend stock with rising earnings and dividends can remain overvalued, and investors who sit tight would reap the big rewards.
What is opportunity cost if you thus sold Coca-Cola (NYSE:KO) in 1991 or on 1995 and purchased Enron stock with the proceeds? Coca-Cola traded at a P/E exceeding 30 at the high points in both years. However, selling at the high in 1991 of $10 would have been a mistake. In addition, selling at the high of 1995 of $20 might have been a mistake also. The reason why it was a mistake was because the company managed to boost earnings rapidly during the period. Only after it went through a rough patch between 1998-2002, did stock prices stall.
Many other quality companies were getting overvalued at the time, which made uncovering quality stocks trading at fair prices difficult. I went through the old stock manuals, and most of the companies that looked attractive in the 1996-1998 period were financials like Bank of America (BAC) and big oil such as Chevron (NYSE:CVX) and Exxon (NYSE:XOM).
To paraphrase Buffett, an individual investor would likely get 20 truly exceptional ideas over their lifetime. If you identified Coca-Cola as a great company in 1989, but either never acted on it or didn't allow the business the chance to show you improving fundamentals after you bought shares, you would have lost one of your chances in life. Luckily, you always get a second chance, or in Buffett's theory 19 more to go.
That being said, there is a nuanced approach to dividend growth investing that lets you keep options open. It's the common sense approach that sometimes for whatever reason you can sell companies. If Coca-Cola trades at 50 times earnings, it might be due for a correction if growth expectations are reduced to even a modest 10% increase in earnings. If other quality companies also trade at a P/E of 40-50, the wise thing might still be to hold on to Coca-Cola. However, if one can find hidden dividend gems that are not only cheaper, but in the buy zone, then a replacement might be in store.
I generally try to be a buy and hold investor, with regular monitoring, whose holding period is usually forever. However, from time to time I tend to sell positions in companies which do not make sense. For example, I sold Con Edison (NYSE:ED) in 2012 and replaced it with Oneok Partners (NYSE:OKS). I also sold Universal (NYSE:UVV) and Cincinnati Financial (NASDAQ:CINF) and purchased Phillips Morris International (NYSE:PM) and five Canadian banks in 2013. Most recently I sold Universal Healthcare Investors Realty Trust (NYSE:UHT) and purchased Digital Realty (NYSE:DLR) and Omega Healthcare (NYSE:OHI).
I essentially replaced lower growth companies with higher growth stocks that also had equivalent if not higher yields at the time of replacement. However, the danger of this exercise is in getting carried away. If all you do is sell lower yielding but higher growth stocks for higher yielding stocks, this could increase risk in portfolios. Investors who purchased a higher yield stock might have taken on more risk, and actually worsened their investment situation. The risk is in terms of diversification, and not playing to different scenarios. For example, why own Chevron when you can own Kinder Morgan Partners (NYSE:KMP). Both are perfectly great companies to own, but I would be much safer owning both rather than just one of them.
When I replaced companies, the first issue I had was that growth was very low and that the price had risen to unsustainable levels relative to similar assets. At the rate of growth of Con Edison, it would have taken me 72 years for my distributions to double. When the yield went from 6% to 4%, I decided to sell and purchase ONEOK, which yielded 4.50% and grew distributions above the rate of inflation. As a result, my dividend income increased by 10%, simply by making the switch. Whether ONEOK actually does better than Con Edison is yet to be seen. However, even if it performs just as well as Con Edison, I would have been worse off, because I had to pay capital gains taxes on the switch. If you compound those issues over time, this could be a serious detractor from long-term performance.
Currently, I own a position in Brown-Forman (NYSE:BF.B). There is a quality of earnings driven by the diverse products that generate strong demand in the US and internationally. The company seems to be doing a good job of growing the business, and rewarding shareholders with high dividends in the process. I believe that ten years from now, Brown-Forman would have at minimum doubled earnings per share. As a result, if it earns $6/share in 10 years, and trades at a P/E of 20, I would generate a good return on investment. The return would be good because I would receive a rising stream of dividends, which typically increase anywhere between 7% - 9%, which I can then use to purchase shares in other companies.
Currently, I do not see companies that are similar to Brown-Forman, which are fairly valued. As a result, I would have to buy a company that is in another industry. A few like IBM (NYSE:IBM) and Wells Fargo (NYSE:WFC) come to mind. Both companies have much lower P/E ratios in comparison to Brown-Forman, and they also have higher yields. Comparing P/E ratios between companies from different sectors is similar to an apples to oranges example. For example, oil majors such as Chevron or Exxon Mobil usually trade at low P/E ratios. The question is, would replacing Brown-Forman with another company affect the risk profile of my portfolio negatively, and would a prudent business owner sell their stake simply because the value of their business is quoted higher?
My options include simply holding on to Brown-Forman and reinvesting dividends in other attractively valued opportunities. My second option includes selling and purchasing a company that is cheaper, such as IBM or Wells Fargo. The main concern is that I want to maximize return for the next 20 - 30 years. If I purchased IBM today, but it fails to increase earnings, while Brown-Forman continues its slow and steady growth, I would be kicking myself in 20 years. If I sold my position in Brown-Forman, I would also have to pay a capital gains tax, as my cost is $39.98/share. If I sold at $72/share, this would be equivalent to receiving $67/share after-tax. Given the fact that I like the company's prospects, I will hold on for now but would closely monitor it if it goes above $80/share.
Unless your income stocks trade at ridiculous valuations such as 30 - 40 times earnings, it might be simply fine to hold on to them. Unfortunately, every situation is different. This is why a black and white approach is dangerous, while a more nuanced and selective approach is superior.
Disclosure: I am long KO, IBM, CVX, OKS, ED, PM, DLR, OHI, BF.B. 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.