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What could a dividend growth investor do when one of their dividend growth companies enjoys a rise in share price? (Note that I wrote "could," not "should".)

Suppose you spend $1,000.00 to buy 100 shares of company XXX at $10.00/share. It pays a total annual dividend of $0.50/share, for a 5% current yield. You receive a total of $50.00 every year. You expect XXX to raise its dividend by 5% every year. You are satisfied.

Time goes by. You wake up one morning and discover that XXX's current price is higher than $10.00/share. What could/should you do about it?

You could calm down, and follow the guideline, "Don't just do something, stand there!" You don't have to sell. No one will force you to sell. No one will laugh at you if you don't sell. After all, you bought XXX because you wanted the $50.00/year in dividends, and it still pays you the $50.00/year in dividends. It is doing exactly what you bought it to do. You are still satisfied.

Let's not forget that if the price goes back down to $10.00/share, and you're back to where you started from, you're no worse off than you were before. The only thing that happened is that you missed out on an opportunity. (If I bothered to count up all of my own missed opportunities, I would throw myself over the nearest bridge.) You didn't make money, but you didn't lose money. You followed Warren Buffett's two rules: "The first rule of investing is don' t lose money; the second rule is don't forget Rule No. 1."

Before you sell, you need to understand why you're selling. Just because the share price went up is not necessarily a good enough reason to sell.

Consider the income stream you would receive if you don't sell. During the first year, you will receive $50.00; during the second year, $52.50; during the third year, $55.125; during the fourth year, $57.88125; etc. What if you hold for four years and then sell at the same price you paid? You would receive a $50.00 + $52.50 + $55.125 + $57.88125 + $1,000.00, or $1,215.50625.

What if you could sell XXX today at $12.16/share, for a total of $1,216.00? The good news is: (1) you don't lose if XXX's dividend rises by less than 5%, and (2) you don't lose if XXX's price rises by less than 21.6%. The bad news is: (1) you don't gain if XXX's dividend rises by more than 5%, and (2) you don't gain if XXX's price rises by more than 21.6%. You limit the downside, but you also limit the upside. (Note that I'm ignoring the issues of taxes, commissions, fees, and the time value of money, in order to simplify the example.)

In some ways, realizing a capital gain today is similar to harvesting several years' worth of dividends in advance. It might not be worth the bother for only a few months' worth of dividends, or only a few years' worth, but for many years' worth, it could be worth doing. This is one reason to sell.

Another reason to sell is if the company's current yield falls below the minimum yield you would require for a new purchase. The thinking is, "If I wouldn't buy it today, then why do I own it today?" I sold WMT a few days ago because its current yield fell to 2.1% -- my minimum yield for a new purchase is 3%. At that time, WMT was not overvalued.

Another reason to sell is if the company is currently overvalued. Many investors have their own way of determining overvaluation. Personally, I use Chuck Carnevale's F.A.S.T. Graphs. I quote SA member AgAuMoney, who wrote: "The market is not perfectly rational, and so sometimes companies are overvalued and sometimes undervalued. Holding an overvalued company is more risky to your capital than holding an undervalued company. So by selling the overvalued [company] and putting the same capital to work in an undervalued company, you have reduced the risk to your capital and likely increased your dividend income."

I sold MCD in December 2011 because it was overvalued. (Note that there are many different definitions of "risk". AgAuMoney is specifically referring to "risk to capital", i.e. probability of capital loss.)

If you sell, then what will you do with the proceeds?

You could stop here and delight in your capital gain. A capital gain raises your wealth. But as SA author David Van Knapp wrote: "Wealth is a means to an end, not the end itself." The end (at least for me) is income, sufficient to fund my retirement, without the need to sell assets to produce cash, and rising by enough each year to counteract the erosion of purchasing power caused by inflation.

Follow AgAuMoney's lead: "...[put] the same capital to work in an undervalued company." How could you identify undervalued companies? My article "What Do I Want To Buy? When Should I Buy It?" addresses that question. It might seem that the market is overvalued today, but I don't buy "the market"; I buy one company at a time, and one company might be undervalued even if the overall market is overvalued.

How do I know that the net result of selling the overvalued company and buying an undervalued company will raise portfolio income?

This question is easy -- if the current yield on the undervalued company exceeds the current yield on the overvalued company, then portfolio income will rise.

Here's an example. You buy 100 shares of AAA. The price/share is $10.00. Your total price is $1,000.00. The current yield is 3%. Each share pays $0.30 in dividends. Your total dividend income is $30.00. Suppose AAA's price rises to $15.00/share. AAA's current yield drops to 2% (dividend is $30.00, price is $1,500.00, dividend/price is 2%). You sell your 100 shares of AAA. You receive $1,500.00 in cash. You buy 10 shares of BBB. The price/share is $150.00. Your total price is $1,500.00. The current yield is 4%. Each share pays $6.00 in dividends. Your total dividend income is $60.00. (Note that I'm ignoring the issues of taxes, commissions, fees, and the time value of money to simplify the example.)

Here is the same information, presented in a spreadsheet:

Buy AAA

Sell AAA

Buy BBB

number of shares

100

100

10

price/share

$10.00

$15.00

$150.00

total price

$1,000.00

$1,500.00

$1,500.00

current yield (%)

3.00%

2.00%

4.00%

dividend/share

$0.30

$0.30

$6.00

total dividend income

$30.00

$30.00

$60.00

I find many things fascinating about this example: (1) The amount you originally paid for AAA is irrelevant; (2) Yield on cost (YOC) is irrelevant; (3) The number of shares of AAA and BBB is very different; (4) The price/share of AAA and BBB is very different; (5) The dividend/share of AAA and BBB is very different. The only thing that is relevant is that the current yield of BBB is higher than the current yield of AAA, so portfolio income rises.

It might sound like I'm recommending that you go out and buy any old undervalued company. I'm not. As always, you must do your own due diligence, and whichever company you buy should be a good fit within your portfolio.

This might seem like magic. How can $1,500.00 spent one way result in more income than $1,500.00 spent another way? It might seem like getting something for nothing. In fact, one SA member wrote: "What you are saying is that you are getting a free lunch. … Certainly, you can sell an appreciated dividend stock and invest in other dividend growth stocks that will pay your more in dividends ... but this occurs because you took MORE RISK. Were this not the case, you could create a dividend growth portfolio that could, at least in theory, create financial perpetual motion". (Note that this person is using a different definition of "risk" than AgAuMoney used above.)

Did we really take more risk? No. To repeat what AgAuMoney said: "Holding an overvalued company is more risky to your capital than holding an undervalued company. So by selling the overvalued [company] and putting the same capital to work in an undervalued company, you have reduced the risk to your capital."

Did we really create "financial perpetual motion"? No. To repeat what AgAuMoney said: "The market is not perfectly rational, and so sometimes companies are overvalued and sometimes undervalued." We have discovered a way to take advantage of Mr. Market's irrationality, to harness the irrationality and make it work for us, instead of against us.

I am grateful to SA member richjoy403 for his feedback and advice to me -- on this article in particular, and on investing in general. Thanks, Rich!

Source: How To Raise Portfolio Income By Selling Overvalued Companies