I hate to sell a dividend growth stock. When I buy a stock, my intention is to hold it forever and enjoy its ever-growing dividend income. Unfortunately, it doesn't always work that way. Sometimes a things change and the stock no longer fits my criteria for inclusion in my income portfolio.
It could be a company that cuts its dividend or in some cases freezes its dividend (fails to raise its dividend at the appointed time). Let's take a look at a two-step process designed to help us determine if we should sell a stock after a dividend freeze.
I. Does The Stock Still Meet Our Investment Criteria? Investing in dividend growth stocks is about about building a reliable income stream that increases each year. When an investment stops raising its dividend, it is no longer providing the future income growth required by my dividend growth portfolio. The stock may still be a good value, but my dividend portfolio’s primary objective is ever-increasing dividend income, not capital gains.
Obviously, the company's future prospects would play into a decision to keep or sell. Can the company raise its dividend, albeit late, and still preserve a year-over-year increase? Will the future earnings provide sufficient free cash flow to pay a dividend? What other obligations, such as debt, might absorb future cash flows? Is management committed to the dividend? Would you buy this stock today as an income investment? This step determines if the stock is a candidate for a sale. The next step asks the critical question ...
II. Are There Better Alternatives Available? Once the stock has been identified as a candidate for a sale, the question then becomes is there something out there that is better? Don't forget in determining the market value of a stock, the market considers any known "bad news" about about a company. So after the bad news is out and the company freezes the dividend, the price may drop and increase the effective yield on the stock. Yield on cost is not relevant when considering a sale.
The current price and current yield are what you will receive and give up when selling a stock. With the cash received is there another stock that would be an "upgrade" from the one you are selling? What does its future prospects look like? Will the new stock replace the dividend income lost from the one sold? What does its debt and cash flow look like? Will it continue to grow its dividend in the future? Is it a more riskier stock?
If in answering these questions you determine the stock should be sold, then you pass step two. At this point, you should sell the stock that failed to raise its dividend and purchase the one you identified in step two.
A Real-World Example I am holding two stocks in my dividend growth portfolio that have not increased their dividends for more than a year. They are:
CenturyLink, Inc. (NYSE:CTL) is an integrated telecommunications company that provides local and long-distance, network access, private line, public access, broadband, data, managed hosting, co-location and wireless. CTL's dividend has been flat at $0.725 since March 2010. The stock is currently yielding 7.4%.
Integrys Energy Group, Inc.'s (NYSE:TEG) dividend has been flat at $0.68 since February 2009. The company engages in natural gas and electric utility operations and non regulated energy operations in the United States and Canada. The stock is currently yielding 4.8%.
Let's run it through the two-step process and see what happens:
I. Does The Stock Still Meet Our Investment Criteria?
- Can the company raise its dividend, albeit late, and still preserve a year-over-year increase? No. Both companies are beyond this point and were removed from various lists that track companies with numerous consecutive dividend increases.
- Will the future earnings provide sufficient free cash flow to pay a dividend? A significant amount of CTL's revenue comes from land-lines. Land-line use is decreasing each year as people choose less expensive alternatives. CTL's declining earnings reflect that. Back when TEG last increased its dividend it was under some very questionable circumstances. TEG recorded a loss per share of $0.92 in 2009. Since then earnings have increased and stabilized.
- What other obligations, such as debt, might absorb future cash flows? In 2008 CTL had $3.3 billion in debt. Since then the debt has grown though several acquisitions to over $21 billion. TEG's total debt has been declining since 2008.
- Is management committed to the dividend? This is subjective, but given the above it will be hard for CTL to increase its dividend in the near-term. TEG is in a much better position to do so.
- Would you buy this stock today as an income investment? I would not buy either today as an income investment.
Based on Step I, both stocks are candidates for a sale. Let's take them through step 2.
II. Are There Better Alternatives Available? Both CTL and TEG have above average yields when compared to other stocks in my dividend growth portfolio. Stocks with a similar or higher yield had risks of their own. Stocks yielding between 4.8% and 7.3% in my database include:
- TC Pipelines, LP (NYSE:TCP) Yield 7.15%
- Main Street Capital Corp (NYSE:MAIN) Yield 6.90%
- Senior Housing Properties Trust (NYSE:SNH) Yield: 6.81%
- Kinder Morgan Energy Partners LP (NYSE:KMP) Yield: 6.06%
- Universal HealthRealty Income Trust (NYSE:UHT) Yield: 5.89%
- Mercury General Corp. (NYSE:MCY) Yield: 5.86%
- Avon Products, Inc. (NYSE:AVP) Yield: 5.68%
- People's United Financial Inc. (NASDAQ:PBCT) Yield: 5.50%
- National Retail Properties, Inc. (NYSE:NNN) Yield: 5.44%
- Leggett & Platt, Inc. (NYSE:LEG) 5.30%
- PP&L Corporation (NYSE:PPL) 5.18%
- National Health Investors (NYSE:NHI) Yield: 5.11%
- Bowl America (NYSEMKT:BWL.A) Yield: 5.10%
- Plains All American Pipeline LP (NYSE:PAA) Yield: 5.07%
- Urstadt Biddle Properties (NYSE:UBA) Yield: 5.01%
- AT&T Inc. (NYSE:T) Yield: 4.94%
You will note that most of the companies above fall into three broad categories: Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs) and distressed companies. The first two have increased tax implications since they do not pay income taxes. Thus, much of the higher yield is attributable to their tax situation.
Companies such as AVP and BWL.A have seen earnings and free cash flow drop recently. T faces many of the same issues that CTL, including long-term loss of land-line revenue.
As for the other Step 2 questions:
- What does its future prospects look like?
- Will the new stock replace the dividend income lost from the one sold?
- What does its debt and cash flow look like?
- Is it a more riskier stock?
- Will it continue to grow its dividend in the future?
There were no sure-fire replacements back when I first did my analysis, given TEG's and CTL's higher yields. At the time, I was not comfortable with the position size I held so I had to do something.
I was fortunate enough to have substantial gains in both CTL and TEG, so I opted to reduce my position in both and keep a close watch on them. Late last year I sold 57% of my CTL shares at a 25% gain. From a cash standpoint the remaining shares can fall to about 50% to $19.78 before I go cash-negative overall. CTL now represents only 0.8% of my dividend growth portfolio.
The story for TEG is even better. Early 2011, I sold 67% of my TEG shares at a 27% gain. From a cash standpoint the remaining shares can go to zero and I will still be cash positive overall. TEG now represents only 0.4% of my dividend growth portfolio.
In this particular instance I was able reduce my overall risk of loss to a highly unlikely level and still continue a position in these higher yielding stocks. Having gains in the stock at the time the dividend was froze allowed me to do this. Under different circumstances, I would have immediately sold my entire position. Since selling TEG and CTL, the share prices have actually risen.
Disclosure: Long CTL, TEG, UHT, NNN, LEG, T in my Dividend Growth Portfolio, and long SNH, WRE, MCY, NHI, UBA in my high-Yield portfolio. See a list of all my dividend growth holdings here.