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Dividend growth investing, retirement
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I recently received an email question, as follows:

On the list of stocks that have been dropped [from the annual 'Top 40 Dividend Growth Stocks,' some of them have been dropped for having a yield that is too low. So let's say I already own [a stock], and two years later the current yield drops below 3%, but my yield on cost is still above 3%. I'm guessing you would drop [that stock] from the top 40 list, but would you sell it as well? Would I be correct in saying it depends on what the yield on cost is at that time?

When and whether to sell dividend growth stocks is a recurring topic in the dividend growth community at Seeking Alpha. Reasonable minds can differ but, normally, yield on cost (YOC) does not play a major role in the decision.

That may sound odd coming from me, given my history of defending YOC as a useful metric. It is true that I think YOC is useful, but not very much when it comes to selling. Here's why: When you are deciding whether or not to sell, your primary view is looking forward. YOC looks backward and right up to the present moment, but it does not look forward.

If you are at a football or baseball game, the scoreboard is a useful device. But almost everything on the scoreboard looks backward or at the present. The score of the game is historical information; it tallies up what has taken place to the current point in the game. The big photo of the player at bat is historical; that's not what he looks like right now. The number of outs, balls and strikes, and first-half statistics are all historical. Scores from around the league are historical or current.

YOC is like a statistic on the scoreboard. It is important, because it tells you what the score is in your program to build a healthy dividend stream from your purchase of a stock some time ago. It can be motivational to think that your original 3% yield on a stock is now spinning out a 6% YOC based on what you paid for it. That can give you real encouragement to stay with your program, and expand it to other stocks as you continue to accumulate assets for retirement.

But YOC is not of much use with a selling decision. I would suggest that the only reason to consider selling a dividend growth stock is to improve your portfolio along some dimension or metric that is important to you. Potential dimensions for improvement are numerous:

  • Diversification
  • Balance among positions
  • Increase the dividend stream
  • Increase the rate of dividend growth
  • Delete or lower your stake in a stock not living up to expectations
  • Take profits in a stock that has had a large price run-up in order to redeploy them into a better opportunity
  • Delete or lower your stake in a stock that has become severely overvalued

Some of these items are related. For example, you can increase a portfolio's dividend stream by taking profits in a stock with a large price run-up that has become severely overvalued, and replacing it with a stock with a better current yield, better valuation, and better prospects for the future.

Notice that yield on cost does not play a role in sorting through these factors.

Let's take as an example McDonald's (NYSE:MCD), a stock widely owned by dividend growth investors. As you can see in the chart below, MCD had a price run-up late last year, which carried it briefly over $100 per share. Its price has since fallen back by about 11%.

MCD Chart

I bought MCD for my public Dividend Growth Portfolio in 2008, 2009, and 2011 at prices ranging from about $54 to $77. Late last year, when MCD's price topped $100, it got everyone's attention and there were numerous discussions about what, if anything, to do. I don't think there is a universal right answer, but I do think that a logical case could be made for anything from doing nothing to selling part of one's holding or to selling all of it.

Here is the case for selling part or all of it: When MCD hit $100, it was significantly overvalued; its current yield dropped to about 2.5%, which is beneath many investors' minimum, and the profit from selling would have equaled a boatload of dividends depending on what you paid for it. At my average cost of about $63, my $37/share profit would have been the equivalent of almost 15 years' worth of dividends at the then-current payout rate. For many investors, McDonald's increase in price would have also increased the company's proportion in their portfolios beyond rules they may have for maximum position size or maximum allocation to any one industry or sector.

But here is the case for not selling: Leave well enough alone. From an income perspective, the stock has performed magnificently in recent years, and it shows no signs of deteriorating in that regard. It has raised its dividend for 35 consecutive years. It raised its dividend last year by 15%, and its one-, three-, five-, and 10-year dividend growth rates are all well into double digits. Let's say that MCD raises its dividend by 10% per year for the next X number of years. Then its payout in 2011 of $2.53 per share will increase each year so fast that it significantly reduces the 15-year "profits equal dividends" calculation from 15 years to nine years.

Year Number

Year

Dividend at 10% Increase per Year ($)

Cumulative Dividends ($)

0

2011

2.53

2.53

1

2012

2.78

5.31

2

2013

3.06

8.37

3

2014

3.37

11.74

4

2015

3.71

15.44

5

2016

4.08

19.53

6

2017

4.49

24.01

7

2018

4.94

28.95

8

2019

5.43

34.39

9

2020

5.97

40.36

(Note that this table does not take into account the reinvestment of dividends, which would probably chop another year or two off the time line.)

Taking all of the above into account, as well as other factors, I did not sell any of my McDonald's stock. Because my goal is to create an ever-increasing income stream for retirement, I decided to leave well enough alone. McDonald's is exactly the type of stock that I want to own.

Could I have made more money by selling? The answer is not obvious. In the very short term, the answer is almost certainly "yes." I could have easily found a stock yielding more than 2.5% and immediately bumped up my income stream by purchasing that other stock.

But there's more to the decision than just gathering an immediate increase in the dividend stream. The replacement stock would have needed to be as fine a company as McDonald's and to have had an equivalent rosy outlook for its future dividend growth rate. Those are much tougher hurdles for a potential replacement than simply finding a higher-yielding stock.

Note that in none of this analysis have I mentioned yield on cost. In fact, the yields on cost of my three MCD purchases ranged from about 3.3% to 4.7% last December. They reflect terrific progress with the stock's income performance. But my happiness with them did not enter into my decision not to sell McDonald's. That decision was based on the other factors that I have discussed.

If McDonald's shoots up again in price at some point in the future, I might reach a different decision. I am on a slow mission to diversify my portfolio from 10 names at the end of last year to between 20 and 25 companies at some point in the future, with no company accounting for more than 15% of the total. I have no time frame for completing the mission. But selling some MCD and using the profits to invest in other companies may well be something that I decide to do. In the meantime, if McDonald's continues to perform income-wise as it has performed up to now, I will happily leave it alone.

Source: Yield On Cost's Role In A Selling Decision