A critical part of managing a long-term dividend portfolio is establishing (and adhering to) an exit strategy. In our opinion, "Buy and Hold" is not a viable strategy. A proper exit strategy should not only establish a plan to exit a losing trade, but it should also include rules about taking profits on a winner. Managing a long-term dividend portfolio is a constant balancing act between maximizing your income and protecting your capital base. Many dividend investors focus solely on the income number and they leave their hard-earned capital in the hands of Mr. Market. Selectively taking profits when you can will give your capital base some long-term stability and it will help protect you from Mr. Market's mood swings.
Generally speaking, we want to let our winners run. But there are times when a stock rallies (and valuations expand) significantly over a short period of time and it's prudent to take some chips off the table immediately. A good rule of thumb that we use for taking short term gains is to sell a stock that has increased over 5 times its dividend yield in a 6-month period. For example, if a stock has a dividend yield of 4.0% and it rallies over 20% within a 6-month period ... it's a good time to take some profits. The theory is that if you can lock in 5 years of dividend payments in a 6-month time frame, you should do it. You can then reallocate this capital into a dividend stock that is trading at a more reasonable valuation to replace the lost income.
Profit Taking Candidates
As previously discussed, we maintain a Buy Zone Watch List of stocks that we want to buy. We also maintain a Profit Zone Watch List of stocks that we feel are overvalued and that we consider to be good profit-taking candidates.
That said, we recently scanned our entire dividend stock universe and came up with a list of 12 dividend stocks that investors should consider cashing in right now. These profit-taking candidates meet the parameters below:
- Parsimony Rating > 60
- Dividend Yield (at 6-month low) > 2.5%
- Yield (Profit) Multiple > 5.0x
- Current P/E Premium (vs. 3yr Avg. P/E) > 20%
We are highlighting each of these stocks over the course of a four-part series. Since these types of stocks are often referred to as "hot" or "on fire," we thought that it would be fitting to separate this group based on some sort of heat index. The first thing that came to mind was the Scoville heat rating of peppers. Below is a schedule of the entire series. If you aren't familiar with the peppers below, we are going from least spicy (poblano) to "burn your tongue off" spicy (habanero).
- Part 1: Poblano (stocks #10-12)
- Part 2: Jalapeño (stocks #7-9)
- Part 3: Cayenne (stocks #4-6)
- Part 4: Habanero (stocks #1-3)
The 12 stocks on our "Ring the Register" list have an average yield (profit) multiple of 10.1x (over the past 6 months) and are currently trading at a 36.6% premium (on average) to their respective 3-year average P/E multiple. In other words, these stocks have had significant short-term runs and we consider them to be overvalued. Note that the yield (profit) multiple is the (1) percent chg. from the 6-month low price divided by (2) the dividend yield at the 6-month low date.
This article highlights the Habaneros (stocks ranked #1-3). The tables and charts below summarize some of the key data points that we look at when analyzing our dividend stocks.
#3 Waddell & Reed Financial (NYSE:WDR)
WDR has very high ratings for Financial Stability (98) and Dividend Sustainability (83) and the stock has performed extraordinarily well over the past few years. In fact, WDR has delivered shareholders a whopping 505% total return over the past 5 years, and it has increased its dividend at a compound annual rate of 8.6% over that period.
WDR is up 107.0% in the last 12 months and 53.0% from its 6-month low and the stock is now trading at a 38.8% premium to its 3-year average P/E multiple. If you were lucky enough to acquire WDR shares near its 6-month low (which equated to a 2.7% dividend yield at the time), your unrealized gains are equal to almost 20 years' worth of dividends! 3 simple words...pigs get slaughtered.
#2 Northrop Grumman (NYSE:NOC)
Northrop Grumman has delivered shareholders a 228% total return over the past five years, and it has increased its dividend at a compound annual rate of 8.5% over that period. Despite NOC's low dividend yield (2.2%), NOC has a relatively low payout ratio (27%) and the company definitely has some room for future dividend growth.
NOC is up 74.6% in the last 12 months and 42.8% from its 6-month low and the stock is now trading at a 43.6% premium to its 3-year average P/E multiple. If you were lucky enough to acquire NOC shares near its 6-month low, your unrealized gains are equal to over 15 years' worth of dividends! There appears to be more downside than upside in the stock at current levels.
#1 Walgreen Co. (WAG)
WAG has the highest Dividend Track Record (99) of any stock in our universe as well as very respectable ratings for Dividend Sustainability (76) and Financial Stability (73). WAG has increased its dividend for 38 consecutive years, including a 13.5% compound annual growth rate over the past 10 years. Walgreen's payout ratio has doubled in recent years, but there is still some decent cushion for further dividend growth.
WAG is up 85.6% in the last 12 months and 35.3% from its 6-month low and the stock is now trading at a 44.8% premium to its 3-year average P/E multiple. If you were lucky enough to acquire WAG shares near its 6-month low, your unrealized gains are equal to over 14 years' worth of dividends! Now could be a decent time to lock in some of those gains as Walgreen's dividend income should be easy to replace.
While this is not an exhaustive list of profit taking candidates, this series should give you an idea of what to look for in your own portfolio. Obviously, your decision to take profits will depend on your specific investment strategy and your cost basis on each stock. That said, we believe that it is prudent to take some chips off the table when a stock becomes relatively overvalued due to a significant short-term rally in price.
Sometimes even good stocks get overvalued and we recommend that investors have a process in place to rebalance their portfolio when appropriate.