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I am proud to say I have become a dividend growth investor for the past few years. I have been reading SA articles relating to DGI strategy and have learned a lot from articles and comments by David Van Knapp, David Crosetti, Chuck Carnevale and few other DGI gurus (I am from India and know what guru truly means, and in my view, they are DGI gurus).

Today I read this great article by Robert Allan Schwartz about whether to sell overvalued companies. The comments section showed how investors are split on how to deal with overvaluation. That inspired me to write my first article in SA. I feel there are a few options for an investor when one of their holdings has gone up in price and they feel it is overvalued. The concept of overvaluation of a stock itself is a judgment call and can vary from investor to investor, hence the options I intend to show may not suit every investor.

In November 2011, McDonald's (NYSE:MCD) dipped below the 3% yield mark and crossed $94/share. I did not sell my position since it was still yielding close to 3%. When it crossed $100/share, there were a few articles about MCD's overvaluation and profit-taking, and I was tempted, as were many investors.

In a situation like this there are few options for an investor, even for DG investors including myself.

  1. Why fix something that isn't broken. So just hold and collect the increasing income. I expect myself to do that as I progress towards retirement (decades away). This is probably the best option for many who do not have the time or inclination to figure out if other options are worth the while. This needs discipline that many lack.
  2. Sell and take the profit and immediately invest in other DG stock that one feels under or fairly valued. I am sure at any given time there are always few candidate from David Fish's amazing CCC list that are undervalued. I am saying from the list because I have learned to be content with the stocks on that list than trying to speculate on growth stocks and lose sleep. This option is the core idea behind RAS's article. He explained it well particularly with the example of selling hypothetical stock AAA and buying BBB which doubles the income. Great strategy and will benefit retires who depend on the income. Even for someone who does not use the income but reinvest it still is a great option.
  3. Same as the previous option but instead of jumping right into the next stock wait a little to find a suitable candidate. The argument against this is the income lost. But in my view we just secured few years of income by selling the overvalued stock. Also another advantage with this strategy is that sometimes the stock just sold (in my case MCD) pulls back and we can get back in on same good company. When MCD crossed $100/share mark I sold my shares and went to cash. While I was waiting for a good candidate that meets my criteria for a new purchase MCD had declined more than 10%. I ended up buying MCD at 88.xx which is little more than 10% discount and hence 10+% more stock = 10+% more income. It is not always possible to get the stock we just sold cheaper but no stock continues the uptrend forever. Moreover this is just an added bonus if it does come down. Else there will be another stock that will be undervalued. For example, around that time Walgreen (NYSE:WAG) stock has been down and, in my view, was undervalued. I did end up buying WAG with the proceeds from selling PM.
  4. Instead of selling the stock one could generate additional income by selling covered call. If stock goes up the holding is bought out albeit for a higher price = more money. If stock price stays same or drops we got some extra cash that decreased our cost basis. For example when MCD crossed 100 one could have sold the 105 covered call and would have kept the profit since MCD never crossed 105. This decreases the cost basis of original purchase. Had it crossed 105 and the shares got bought, one still came a head because if one feels 100 is overvalued 105 certainly is.
  5. Selling naked put. This is one of my favorite strategies. I use it to enter a position cheaper than market price. For example, when MCD crossed 100 sell the shares. But we like it so much that we want to own it. Now sell a $95 naked put to buy it back. If it never gets assigned we get to keep the put premium as income. If we do get assigned then we just sold MCD above 100 and bought back for less than 95 (95-put premium). A little over 5% cheaper = 5+% more shares could be bought = 5+% more income.

Strategy 1 works for everyone since it does not need any special understanding of valuation or technicals. Strategy 2 and 3 needs understanding of valuation but that has become relatively easier today with Chuck Carnevale's FAST graphs. Strategy 4 & 5 needs understanding of valuation and options.

On top of this an understanding of basic technical analysis can help a lot. Just simple resistance, support and relative strength index (RSI) is all I use. In my view over analyzing using technical analysis will lead an investor to become a trader. I have known many investors make decent return consistently but not even a few traders that can keep up with S&P index return.

Source: How To Deal With Overvaluation Of A DGI Holding