Is Now the Time to Sell Your Dividend Stocks?

The strong bullish move off of March 2009 lows has lifted many stocks, thus creating large unrealized paper gains for many dividend investors. While prices have enjoyed a steep run-up, dividend yields, which move inversely to prices, have declined in the process. Many dividend investors are now wondering if they should simply lock in their gains in stocks which are not yielding that much relative to others.

As a dividend investor, one of the items in my entry criteria is to require at least a 3% initial yield when purchasing a stock. Back in the first half of 2009, there were plenty of good quality dividend stocks that fit these criteria. Nowadays even some of my favorites such as PepsiCo (PEP) and Aflac (AFL) are yielding a little less than 3%. Now that those holdings are yielding less than my entry yield criteria, the question is whether I should hold on to them, or switch to stocks with higher current yields. If I were to do this, I would instantly increase my dividend income. If I didn’t however, that wouldn’t really hurt my income either.

First, the reason why I won’t do this is because I am a long term investor. I buy stocks and plan to hold on to them for the long run, or until a company cuts dividends. Over time I expect that a dividend grower would deliver a solid yield on cost. In other words if I purchased Johnson & Johnson (JNJ) at $50 in March, my yield on the original investment would have been 3.68%. After the company raised its annual dividend however to $1.96/year, my yield on cost increased to 3.92%. If JNJ raises distributions at 6% annually for the next 12 years, my yield on cost would double to 8%. More often than not however, the current yield on Johnson & Johnson (JNJ) would remain between 2% and 3% over the next decade. That is, if Johnson and Johnson pay a $4 dividend in one decade, and the stock yields 2%, the stock price would be $200. Most dividend yield chasers would be ignoring the stock simply because the yield is too low. At that moment however, my yield on cost would be 8%, and I wouldn’t care as much about the current yield, except when reinvesting distributions.

Therefore it is important to distinguish between yield on cost, and current yield. If you purchase a stock whose dividend payment increases over time, chances are that your yield on cost would be increasing. Thus, even if the current yield drops to 2%, one should not consider selling. Another example in this situation is Aflac (AFL), which could have been purchased around $12 at its lows in March, yielding about 10%. Despite the fact that the stock is up over 300% since that point and yielding 2.4% currently, this investment would still be yielding 10% on cost to the investor who bought at the time.

Second, you have to take into account the dividend yield and dividend growth characteristics in addition to evaluating the sustainability of the dividend. If you purchased Procter & Gamble (PG), at prices between $45 and $50, your yield on cost is somewhere between 3.50% and 3.90%, despite the fact that the stock currently yields 3.10%. The ten year dividend growth rate for this Cincinnati based manufacturer of consumer goods is 10.60%. Using the rule of 72, the company would double your yield on cost in 7 years. In addition to that the dividend payment is adequately covered from current earnings and cash flows per share.
Let’s assume that you decided to sell your Procter & Gamble (PG) stock today for a higher yielding company such as AT & T (T), which currently yields 6.30%. While you would essentially double your dividend income overnight, you would have to note that AT&T (T) has grown its distributions by 5.3% annually over the past decade. In addition to that, the payout ratio of the telecom company is approaching 80%, which puts the sustainability of the distribution in danger. Last but not least, by switching from Procter & Gamble (PG) into AT&T (T) would lead to your portfolio being overweight to the telecommunications sector and underweight the consumer staples sector.

At the end of the day it is important to understand that investing is more art than science. Thus, while a strategy might look good on paper, does not mean that it would stand the tests of the battle. It is also a balancing act between several known and unknown variables, such as dividend yield, dividend growth, dividend payout, diversification and dollar cost averaging. If your portfolio consists mainly of high yielding securities, there is a very high probability that the dividend payouts on your investments is high, which increases the likelihoods for a dividend cut, and the opportunities for income growth are limited. It is important to view stocks as ownership portions of businesses, and thus concentrate on selecting only those which the investor believes to have solid fundamentals over time.

Two such companies include Johnson & Johnson (JNJ) and Procter & Gamble (PG). Both companies are leaders in their own markets, and possess strong economic moats.

The Procter & Gamble Company engages in the manufacture and sale of consumer goods worldwide. The company operates in three global business units (GBUs): Beauty, Health and Well-Being, and Household Care. The company has raised distributions for 53 years in a row. (analysis)

Johnson & Johnson engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company has raised distributions for 47 consecutive years. (analysis)

Both companies offer not only great dividend growth potential, but also strong capital gains potential as well for the enterprising long term investor. While investing in the short run is mostly affected by strong emotions such as fear and greed, long term dividend investing is all about evaluating long term business trends and then positioning accordingly.


Disclosure: Long AFL, JNJ, PEP, PG and T

Comments

[davidbdc:]

Nice article. One point I would differ on is that J&J offers good dividend potential and for those that bought over the years at 25, 35, 45 will do well. But I disagree that there is capital gains left. This is one ship that has been drifting aimlessly since Larsen retired and unless there is wholesale change in the executive management ranks they won't see $75......ever.

Oct 23 08:50 AM

[Old Trader:]

An excellent article, pointing out some of the nuances of running a successful income producing portfolio. One minor quibble with the advice given in the example of swapping out PG for T, at this point.

If the investor was, say 65+ years old, he/she might benefit more from the increase in current income by making such a shift, rather waiting for what might happen 10-15 years down the road.

Oct 23 08:54 AM

[bobbybutte:]

I only swap out of a dividend stock if the PE goes over 30 or if the ownership does something irrational like the Pfizer or GE CEO have done in the past year

Buy and hold works I have achieved financial security from it the key is getting your money in right with the right stocks and staying the course

That interest free loan from the IRS on the cap gains is HUGE

ask warren Buffett he has about 35 billion worth haha

Oct 23 09:04 AM

[mbkelly75:]

Well written article - cost-basis over time is SO important. I keep track of it for every stock that I own from the very first day in a log that I have kept in various forms for over 50 years. Zero cost-basis on a stock that is paying a reliable, rising dividend is the Holy Grail for me. A lot of times I have traded to get more of a zero-cost stock by buying at a low point when the stock has started trending up(indicated by a Golden Cross for timing), and sold enough to pay all expenses when it has hit a high point and starts trending down (indicated by a Death Cross) and have the shares left over with a zero cost-basis to add to my Core Portfolio to increase my dividend income. I also have my brokerage account set to automatically re-invest dividends and interest in the instrument that paid them. If I need the cash instead, one click lets me keep the cash and one more resets the account back to automatic re-investment. This has worked well for me for a VERY long time.

Oct 23 09:35 AM

[indefinitelee:]

I tend to agree with most of your articles but I really see nothing wrong with taking a bit of profit on some stocks that have run up close to 50% over the last few months.
You could either buy back into the same stock on dips or use the profits to expand or enter into another position.

Oct 23 09:53 AM

[David Van K...:]

Good article and good comments. Once you own a dividend stock, yield on cost, not current yield, becomes "your" yield. All of the previous commenters have made good points and suggestions. One that struck me is Old Trader's, which points out the difference in perspectives between someone young and accumulating wealth as compared to someone retired and living off the income from his/her dividend stocks. Another is mbkelly's technique for making targeted trades that, over time, leave him playing with house money eventually.

Oct 23 09:55 AM

[StockData.org:]

I took some money off the table recently after the recent 6 month run up. I did not sell out any positions 100%-- just trimmed them down a bit and increased my cash. My gut tells me we'll have more buying opp's soon and thus I will be able to expand my portfolio to other stocks faster.

Oct 23 10:37 AM

[poortorich:]

i agree with Bobbybutte

In general, i tend to keep high quality companies with enduring competitive advantages that can consisently earn high returns on invested capital. Over a long period, they will provide you with great returns. However, if one of these companies were to go up in price where the pe goes to 25 or so, then i would use the dividends and reinvest those in other buffett type of companies. I would still not sell because of the capital gains tax, which is not insignificant and which will probably go up in the future. The only exception is if i'm in a retirement account...in which case i would sell the buffett type company with a pe of 25 and buy another buffett type company with a much lower pe. (for example, in my retirement account, if the pe of KO goes to 25, but jnj drops to where its pe goes to 10, i would sell all my ko and buy jnj at a pe of 10).

For my non-retirement account where taxes are a major factor, my rules are similiar. But i'm willing to let the pe go higher. As an example, ko's pe is now around 20.... I would not use the ko dividends to buy more ko. I would use them to buy something like ABT, JNJ , which are better values right now. I wouldn't necessarily sell KO at this level bc of the capital gains. However, if the pe of KO went to 30 or over, I have to sell because all the money in KO would essentially be "dead" money for the next 7-10 years....essentially you would looking at a great company at an outrageous price. Look what KO did after its PE was something like 30-50 a decade or so ago....it went nowhere.

Another thing about dividends....i am a huge fan of dividend paying stocks. However, if a company can get a good return on retained earnings, i would rather they not pay out the dividend. As an example,if Ko had not paid out dividends and kept it as retained earning, your return would have been better because they can not only get better returns on your retained earnnings,but you would be avoiding double taxation.

If a company can provide 15-20% return on retained earnings, i would much rather they keep the earnings and not pay a dividend.


On Oct 23 09:04 AM bobbybutte wrote:

> I only swap out of a dividend stock if the PE goes over 30 or if
> the ownership does something irrational like the Pfizer or GE CEO
> have done in the past year
>
> Buy and hold works I have achieved financial security from it the
> key is getting your money in right with the right stocks and staying
> the course
>
> That interest free loan from the IRS on the cap gains is HUGE <br/>
>
> ask warren Buffett he has about 35 billion worth haha

Oct 23 12:20 PM

[user396040:]

I would like his thoughts on BMY, KO, XOM, and VZ from a dividend investor point of view.

Oct 23 12:36 PM

[notsosmart:]

if you go in @ the low like last march & the co does not cut the div your yield will always be the same.last year my yield was 7.2% if you are young & have time on your side the drip program is the way to go.you pay little or no fees & $ average.it worked great for me in getting some crumbs from this wall st ponzi/casino.now im retired i take all my divs + my social security i can be comfortable.i still buy good div cos on the dips.it doesnt matter to me that all of the purchases i made in march are up.as long as the income keeps coming the stock price means little to me.some of my tanker stocks the div paid for all the stock.cant beat zero cost even when they cut the div.so think for yourself before you pay more taxes & fees.

Oct 23 03:39 PM

[GotLife:]

Lots of great ideas. Any comments on covered calls for income? How active covered calls might affect your decisions during these times? I find the yields in trading covered calls in my IRAs can often match or exceed the dividend income.

Also, I like they currency/inflation protection offered by international companies like PG. A lot of health care stocks were mentioned and many do offer currency protection as large multinationals but is anyone concerned about the effects of Obama care on the health care industry and their ability to grow revenue and hence dividends?

Oct 24 04:22 AM

[La Marque:]

Most retail investors do not have capital gains on most of their dividend payers; rather they have capital losses. Most did not get out before the crash and have a high cost basis. They also did not get back in the market in March 2009, because they never left.

Oct 24 11:18 AM

[Dividend Di...:]

Interesting comments by all. I would pose a question to davidbdc though. Can we consider JNJ to have good dividend potential on one hand but call its capital appreciation suspect on the other? If by "good dividend potential" you mean solid, long-term dividend growth, that means over time the dividend must remain well-covered to meet those growth objectives. In order to be well-covered the company must increase earnings. Earnings drive stock valuations. If we argue that JNJ is a solid LONG-TERM dividend grower, shouldn't we expect price appreciation to follow the increase of a well-covered dividend?


On Oct 23 08:50 AM davidbdc wrote:

> Nice article. One point I would differ on is that J&amp;J offers
> good dividend potential and for those that bought over the years
> at 25, 35, 45 will do well. But I disagree that there is capital
> gains left. This is one ship that has been drifting aimlessly since
> Larsen retired and unless there is wholesale change in the executive
> management ranks they won't see $75......ever.

Oct 24 12:04 PM

[GotLife:]

Valuation models calculate the current stock price to equal net present value sum of all future cash flows divided by the number of outstanding shares. The answer to your question is somewhat tied to inflation expectations. JNJ could grow in nominal terms, both in revenue and dividends, while not exceeding inflation, yielding increased income to investors in future years but without real capital appreciation. Thus, unlike bonds, their income profile may allow for inflation adjusted income and value without real dollar growth in either.

On the other hand, if revenues and cash flows out pace inflation, capital gains will occur in real dollars and provided the corporate strategy remains intact, a real dollar increase in dividends.

Of course the Feds have the best gig of all since they tax you on both the nominal and real capital gains, yet another reason for them to allow continuing monetary expansion.


On Oct 24 12:04 PM Dividend Disciple wrote:

> Interesting comments by all. I would pose a question to davidbdc
> though. Can we consider JNJ to have good dividend potential on one
> hand but call its capital appreciation suspect on the other? If
> by "good dividend potential" you mean solid, long-term dividend growth,
> that means over time the dividend must remain well-covered to meet
> those growth objectives. In order to be well-covered the company
> must increase earnings. Earnings drive stock valuations. If we
> argue that JNJ is a solid LONG-TERM dividend grower, shouldn't we
> expect price appreciation to follow the increase of a well-covered
> dividend?

Oct 24 12:36 PM

[Plan B Econ...:]

There were lots of great yields out there a few months ago. Not so much anymore. If I look at yields as a valuation metric I'd say the market is fully-valued.

Emerging market debt ETF yields about 6.5%...Sure the spread over treasuries is high, but the absolute number is quite low.

The easy money has been made. I'm taking some $$ off the table...the risk-reward just isn't worth it anymore. Obviously I could be wrong, but I'm not comfortable with the downside risk that exists today.

www.planbeconomics.com.../

Oct 24 03:56 PM

[bobbybutte:]

As a person who has achieved financial independence SOLELY from investing I believe to get great entry points in the stocks with the widest moats and hold them unless you see xecessive valuations like we did in 1997 .You can get rich I know because it happened to me.peace

Oct 25 10:59 AM

[ArtfulDodger:]

Very good article. Good comments all the way down. One other point:

I fully understand long-term investing, but with rates at 1/4%, I think it would be prudent to consider making some moves when the Fed starts its upward move.

Perhaps not selling core holdings, but at least consider some stocks that tend not to do as well in a higher rate atmosphere.

Oct 26 12:21 PM