A critical part of managing a long-term dividend portfolio is establishing (and adhering to) an exit 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 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 trim your position 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.
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 16 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) > 2.0%
- Yield (Profit) Multiple > 5.0x
- Current P/E Premium (vs. 3-yr. Avg. P/E) > 25%
We will highlight each of these stocks over the course of a 4-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 #13-16)
- Part 2: Jalapeno (stocks #9-12)
- Part 3: Cayenne (stocks #5-8)
- Part 4: Habanero (stocks #1-4)
The 16 stocks on our "Overvalued" list have an average yield (profit) multiple of 7.3x (over the past 6 months), and are currently trading at a 36.3% 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) % 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 #1-4). The tables and charts below summarize some of the key metrics that we look at when analyzing whether or not to take profits in our dividend stocks.
#4 Cummins Inc. (NYSE:CMI)
Cummins is up 23.1% from its 6-month low of $123.70, and it is currently trading at a 35.8% premium to its 3-year average P/E of 13.6x. Based on a dividend yield of 2.0% at the 6-month low date, the potential short-term yield (profit) multiple is 11.4x (i.e., if you bought near the 6-month low, your current profit would equal ~11.4 years of CMI dividend payments).
#3 Illinois Tool Works (NYSE:ITW)
Illinois Tool Works is up 12.7% from its 6-month low of $76.78, and it is currently trading at a 57.2% premium to its 3-year average P/E of 14.7x. Based on a dividend yield of 2.2% at the 6-month low date, the potential short-term yield (profit) multiple is 5.8x (i.e., if you bought near the 6-month low, your current profit would equal ~5.8 years of ITW dividend payments).
#2 Walgreen Co. (WAG)
Walgreen Co. is up 25.6% from its 6-month low of $55.57, and it is currently trading at a 45.0% premium to its 3-year average P/E of 16.95x. Based on a dividend yield of 2.3% at the 6-month low date, the potential short-term yield (profit) multiple is 11.3x (i.e., if you bought near the 6-month low, your current profit would equal ~11.3 years of WAG dividend payments).
#1 General Dynamic Corp. (NYSE:GD)
General Dynamic is up 31.7% from its 6-month low of $89.23, and it is currently trading at a 55.7% premium to its 3-year average P/E of 10.6x. Based on a dividend yield of 2.5% at the 6-month low date, the potential short-term yield (profit) multiple is 12.6x (i.e., if you bought near the 6-month low, your current profit would equal ~12.6 years of GD dividend payments).
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, cost basis on each stock, and potential tax consequences. That said, we believe that it is prudent to trim your position 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 "ring the register" when appropriate.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.