How to Replace Sold Dividend Stocks

Dividend investors should not rely too much on the dividend income from a single stock or a single sector. In an ideal situation, in a portfolio consisting of 40 stocks, each security would have an equal weighting. In other words one shouldn’t have more than 2.5% in a single security at the end of his or her target period.

In real life however things are usually far from ideal. What could happen is that some dividend stocks would outperform the others and thus their weightings could be disproportionately large. In order to maintain the equal weights, investors have several choices besides selling the best performers and placing the proceeds in the underdogs.

One of them includes reinvesting the dividends from the stocks with the highest weights into the stocks with the lowest weights.

Another option includes adding extra funds to the stocks which have a below average weighting in your portfolio, as part of your process of regular contributions toward your portfolio.

An important thing to add is that one should not consider adding to a position, which no longer fits two or more points from your entry criteria. My entry criteria consists of several bullet points including:

1. A stock which has increased annual dividends for at least the past ten consecutive years (preferably for at least 25 years)
2. A price/earnings ratio of under 20
3. A dividend payout ratio of less than 50%. In certain cases such as Master Limited Partnerships, Utilities or Real Estate Investment Trusts, which distribute the majority of their earnings to stockholders, compare the current payout ratio to the historical one.
4. A dividend yield, which at least matches the dividend yield on the S&P 500. This criterion used to be a 2% initial yield for the majority of 2008, until yields on the S&P 500 rose to the highest levels since the early 1990’s. Currently I prefer to invest in stocks with a current dividend yield of at least 3%.

For example, if you have a position in M&T Bank (MTB), you would be receiving a quarterly dividend of $0.70/share. M&T Bank last raised its dividends in July 2007. Unless the bank raises its dividends by the end of 2009, it would lose its dividend aristocrat status.

Because of the unchanged dividend, I stopped re-investing dividends in the stock by the end of 2008. I also stopped adding to this position as well. The dividend payout is slightly above 50%, while the P/E and the yield are pretty attractive at 12.7 times earnings and 6%. Another thing that concerns me about M&T Bank is that it took $600 million in TARP money back in December 2008. My experience with other banks, which received TARP money, such as Bank of America (BAC), US Bancorp (USB), Wells Fargo (WFC) and BB&T (BBT), is that TARP receivers are very likely to cut their dividends.

Since I have started reinvesting my MTB dividends into other companies I own, my allocation in the stock has dropped to about 1.7% of my total portfolio value. This position contributes about 2.20% of my total annual dividend income. My yield on cost is 4%. If the dividend were cut while the stock was trading at $46 however, I would sell the stock.

The question now is what should I do with the money I received from the sale. My dividend income would be lowered, and I would now have $46 to invest, which is lower than my average cost of $69/share. In order to maintain my dividend income of $2.80/share, I would have to purchase $46 worth of shares in a dividend stock, which currently yields at least 6%. In the current market it is possible to find a solid dividend stock, which yields at least 6%. One example that comes to mind is Consolidated Edison (ED). Another is Kinder Morgan Partners (KMP). It is important to try and keep sector weights as well however.

On the other hand I could simply accept that my dividend income for this portion of my portfolio would be lower and simply invest in a promising candidate such as Johnson & Johnson (JNJ) or Abbott (ABT). It is more important to have a diversified stream of dividend income, rather than chase the highest yielding stocks when replacing dividend stocks sold in an effort to maintain your previous levels of dividend income. Check my example with General Electric (GE) for more clarification.

Back in February 2009, General Electric, which was one of my favorites until the end of 2008 announced its intention to cut its quarterly dividends to the lowest levels since 1997. I immediately sold my position at a loss for $8.63/share. My cost basis was $28.97/share. My dividend income was $1.24/share, while my yield on cost was 4.30 %. The new dividend would have been $0.40/share, which makes up for a yield on cost of only 1.40%, much worse than rates on Certificates of Deposit. Even though I had stopped contributing to my GE position by the beginning of the fourth quarter 2008,GE made up about 1.00% of my portfolio value. This position also contributed about 3% of my total annual dividend income. Thus, in order for me to generate $1.24 in dividend income for every GE share that I sold, I would need to purchase a stock yielding 14.40%. In the current market, most stocks that pay such a high current dividend are very likely to cut their distributions. Thus, maintaining the dividend income just for this portion of my dividend portfolio was not worth the risk of chasing the highest yielding stocks. Instead I purchased shares in Abbott Labs (ABT), which generate almost the same income that I would have received had I not sold my GE shares. While in retrospect my sale of GE stock seems foolish as the shares have risen almost 50% since then, I do not see the same potential for dividend growth that I see for Abbott. With Abbott I see the potential for stable dividend growth, fueled by its strong new product pipeline and the potential for initiatives in the medical device and pharmaceuticals fields. In retrospect I could have added to my position in Kinder Morgan instead, but this could have lead to me being overweight the largest master limited partnership in the US, which is something I try to avoid.

My overall dividend income is up almost 3% year to date, after several reliable companies such as Johnson & Johnson, Procter and Gamble (PG) and Coca Cola (KO) continued their long history of sharing prosperity with shareholders through regular annual dividend increases.

Dividend investors who are trying to replace the lost dividend income from stocks, which cut or eliminated their dividends, should realize that it is important to diversify the number of holdings that generate income for them. While a dividend cut or elimination from a stock that generated 3% of your portfolio income hurts, one should keep an eye on the big picture and not repeat their mistakes. It is the diversified income stream that counts and not replacing dividend stocks sold with the highest yielding stocks matter, which would certainly increase risk. At the end of the day, the dividend cutter has already compromised your dividend income. Taking on a higher risk only leads to a vicious circle of not focusing on dividend growth potential, but on chasing the highest yielders, which is a game of wealth destruction.

Comments

[agedvet:]

What do you all think of the sale of covered calls to supplement dividend income? Believing GE to be oversold, I increased my position despite the dividend cut and sold July 12.5's. I have also used the same strategy with NAT.

Jun 03 11:22 AM

[Dotcom:]

I certainly appreciate the information in this article. My current perspective is to try & buy at reasonable (relatively low) NAV, don't get greedy with over allocation in MLPs and more so with non-MLP high yielding stocks + stay diversified even in dividend paying stocks.

Thank you for the information, perspective & methodology.

Jun 03 12:26 PM

[Michael D.:]

I just did my own calculation on this yesterday. AFL has run up, but my yield on ACB is over 6%. If I sold and took profits, I'd have to replace it all with stocks yielding at least 4.5% to maintain income.

From a portfolio re-balancing perspective, it is a rough (but effective) tool to force you to buy low and sell high. Buying high yields (healthy companies) suggests you are buying low price. Selling low yields suggests you are selling high. But beware, calculate your yield on ACB and you'll think twice before selling.

Well selected/constructed portfolios inherently involve less trading.

Jun 03 01:23 PM

[buoy:]

Right on, machine.

Jun 04 09:28 AM

[David Van K...:]

Good article and good comments.

I like to place my money with my best ideas, so I would not consider having a 40-stock portfolio and a target of 2.5% of my money in each stock. I believe I can create a "well-rounded" portfolio with about 10-15 stocks. Within that framework, I diversify across several dimensions: Industry; yield; dividend growth; and so on.

Like the author, I generally sell when a company cuts its dividend, although it is not a hard-and-fast rule. This author and others have well documented that a dividend freeze or cut usually foreshadows difficult times for the company. Most long-term dividend-paying companies do not cut their dividend casually--they probably foresee diffficulties down the road, quite possibly based on information which is not publicly available.

That makes dividend actions (increases, freezes, or cuts) the "canary in the coal mine." Because of this, when I do sell, I tend to look for companies that have recently made a healthy increase in their dividend (as well as satisfied my other criteria, which you can see here: www.sensiblestocks.com... ). Several good dividend stocks have declared dividend increases of 7%+ already this year, including ABT (11%), CL (10%), PG (10%), KO (8%), LNT (7%), JNJ (7%), and WMI (7%).

Jun 04 09:44 AM

[YoYoMama:]

Excellent article.

This may be a simplistic approach, but it works for me. In a portfolio of about 20 - 30 dividend paying stocks, I add up the total dividend payout at the end of each month. I take that total figure and make one reinvestment transaction into one stock holding. The criteria for the stock that would receive the reinvestment may vary month to month, depending on the current environment, but it is safe to say that a key criteria is that it is a holding that requires rebalancing.

This keeps my transaction costs for reinvestment to $7 per month, away from a potential $210. Fees are the little foxes in the vineyard that can eat away your harvest, so I try to keep fees down as much as possible.

I would love to be in a position to be adding loads of cash into my IRA for the purposes of rebalancing. But I have three teenagers at home, and they are quite expensive!! So I am forced to continually rebalance, shaving off profits or cutting my losses when I can, and reinvesting in the stocks that are more underwater.

It's not exactly a scientific approach, but my portfolio is up 60% from the market lows, so I suppose even a simpleton like me can benefit from the approach that Dividend Growth Investor recommends.

Again, great article.

Jun 04 10:40 AM

[Crankly09:]

Is it a wise idea to buy into some of the better companies out there, who are down in pps and that have cut their yield for the near future, so that when the economy turns around you can win on both angles?

Example- GE. GE is hovering a $13 and it was above $30 a year ago. I know that the share price will rise over the nextcouple of years to those same levels (or near them) and that GE will re-instate their dividend generosity at that time. Why wouldn't someone want to load up now on GE at $13 and turn this stock into both a growth winner and a future dividend play?

Very curious to hear your responses and thanks!

Jun 04 03:22 PM

[Living4Divi...:]

Great article - especially about diversification "Dividend investors should not rely too much on the dividend income from a single stock or a single sector. In an ideal situation, in a portfolio consisting of 40 stocks, each security would have an equal weighting. In other words one shouldn’t have more than 2.5% in a single security at the end of his or her target period."

Some experts are now suggesting 50 stocks. But, 40 Stocks sounds good.

Diversifying across sectors is just as crucial, if not the most crucial. If you had a portfolio of mainly financial stocks in 2007 you would have gotten creamed in 08 and 09.

Jun 04 03:31 PM

[connorport:]

I don't understand this way of thinking. Just because dividend yields are cut doesn't mean you can't retrieve income from the stock. In fact i bought heavy in GE when it hit $6 which at that point even with the cut would yield 6%. To regain some needed cash it would be smart to play the covered calls between earnings. Sell short on earnings run up and buy to cover when the stock retreats. If your'e conservative about your covered options play then any lost dividend yeilds could be earned back easily. With the up/down swings going on you can buy and sell almost weekly right now.

Jun 04 05:08 PM

[connorport:]

If you stay conservative with your covered call plays then you can do better that dividend yields right now. I did the same thing and added volume to my shares and lowered my overall averages. If one would look out to 2010 or 2011 you could probably expect a dividend reinstatement which would drive the stock back upwards by people like our gracious writer here. Play the covered calls and chase the value upwards when its moving up and buy back to cover when it drops. Either way you win on the deal.


On Jun 03 11:22 AM agedvet wrote:

> What do you all think of the sale of covered calls to supplement
> dividend income? Believing GE to be oversold, I increased my position
> despite the dividend cut and sold July 12.5's. I have also used
> the same strategy with NAT.

Jun 04 05:14 PM

[connorport:]

I am personally waiting for the next earnings report as i think we shall start to see a stronger GE as they have invested heavily in a down market which makes sense. They are also in line with worldwide stimulus that could capture them heavy profits for years in China alone. I would buy back to cover and wait for earnings and you could fetch a lot higher price on say 15' or 16's.


On Jun 04 05:14 PM connorport wrote:

> If you stay conservative with your covered call plays then you can
> do better that dividend yields right now. I did the same thing and
> added volume to my shares and lowered my overall averages. If one
> would look out to 2010 or 2011 you could probably expect a dividend
> reinstatement which would drive the stock back upwards by people
> like our gracious writer here. Play the covered calls and chase
> the value upwards when its moving up and buy back to cover when it
> drops. Either way you win on the deal.

Jun 04 05:18 PM

[Advill:]

Totally agree, now GE is with around 9% yd, so where was the hurry in selling a stock with a clear path, buying GE now is a CD of 8% plus capital growth....give just 3 like that!.
Regards.


On Jun 04 08:57 AM dividendmachine wrote:

> As aperson who has actually achieved financial independence by owning
> dividend stocks let me take issue with a few comments here
>
> 1) A company which has raised their dividend 10% annullay on average
> but didnt raise their dividend 1 year hardly should be eliminated
>
>
> 2) 98% of my dividend income comes from one sector:however tobacco
> has been the most relaiable like it or not
>
> 3) PE of 20 :actually entering stocks with Pes under 15 will do MUCH
> better
>
> 4) the dividend payout ratio is misleading:a company with stable
> earnings can pay out a higher ratio especially if they have a higher
> ROE and are leaders in their industry and for antitrust purposes
> can not make acquisitions
>
> Remember folks the whole key is to find the right companies at the
> right price.the best returns over the past 50 years have been consumer
> goods companies or big pharma.peace

Jun 09 06:37 PM