Considering The Opportunity Costs Of 'Trading Dividends'

| About: The Coca-Cola (KO)

There's been a lot of chatter lately about deciding when or if one should sell a dividend growth stock. In fact, I recently weighed in on this subject by suggesting that there are two qualifications that would effectively "make me sell": if the company lost its fundamental ability to keep increasing payouts or if the market happens to offer me a price way above what I might think to be reasonable. Of course a universal qualification must be made to these scenarios. Given today's low-interest cash alternatives and the opportunity costs of moving from equity to liquidity, the person selling a dividend growth stock would have to find not only a reason to sell, but also a practical substitute for their funds. Granted the urgency of this replacement loses some luster in a more competitive interest environment, but it remains that equity investments likely outperform holding cash equivalents over the long-term. This is especially true if your primary concern is building a stream of ever growing purchasing power.

But there's more to it than just selling say Coca-Cola (NYSE:KO) and buying shares of say PepsiCo (NYSE:PEP), when the former has a larger price multiple than the latter, right? And of course the answer is: yes absolutely. I would liken simplifying your buying decision to "KO is trading at a greater multiple than PEP, therefore I sell/buy" to the unhelpful advice of "buying low and selling high". That is, there's more to it than just glancing at the two securities. To better illustrate this point, let's run through an illuminating example. Consider a $5,007 investment in Coca-Cola in the beginning of 2003:

Year Price Dividend Shares Payout Yield
2003 $44 $0.88 113.6364 $100.00 2%
2004   $1.00   $113.64  
2005   $1.12   $127.27  
2006   $1.24   $140.91  
2007   $1.36   $154.55  
2008   $1.52   $172.73  
2009   $1.64   $186.36  
2010   $1.76   $200.00  
2011   $1.88   $213.64  
2012 $77.20 $2.04   $231.82 2.64%

Note that I added the $7 to account for the frictional expense of making a buy transaction. Assuredly this cost varies by person and broker, but is a reasonable graphic of a common experience. We see that Coca-Cola increased in price from around $44 in 2003 to about $77.20 today; a 6.4% yearly increase. Now before anyone says anything, I am well aware that Coca-Cola split their shares this year. I simply doubled the share price instead of doubling the share count. Call it a reverse split adjusting if you want, but it's the same math. For simplicity we assume that you do not reinvest the dividend payouts. We also see that the dividend increased by an average yearly rate of about 9.8%; which means that the current yield would have to increase. And in fact this is the case, moving from 2% to 2.64%. (((1.098^9) / (1.064^9))*starting yield) The much debated yield on cost would be about 4.63%, but we'll stick strictly with income for comparison purposes.

Now let's assume that you believe that PepsiCo will be able to grow its dividend at precisely the same rate as Coca-Cola for the foreseeable future. This isn't necessarily practical, but it's not absurd. One would be replacing the number one beverage maker with the still incredibly strong number two beverage maker and a shelf monopolizing snacks business to boot.

PepsiCo currently trades around $71 a share, with a $2.15 dividend; translating to a 3.02% yield. On the other hand, your Coca-Cola shares are giving you an income return of about 2.64%. If you believe PEP and KO will grow dividends at the same rate and you only care about an increasing level of income, then it seems obvious to drop the KO shares and buy PEP, right? It seems logical, after-all that 3.02% yield for PepsiCo would generate about $265 in income on your $8,770 value of Coca-Cola. This compares to just under $232 in income if you hang on to the KO shares or about $33 less. Given our assumptions, you would continue to make more money by owning the PepsiCo shares.

But of course it isn't as simple as comparing current yields. We must factor in frictional expenses and taxes. Let's see what happens when these inopportune expenses are added in:

Action Shares Company Cost / Gain
Sell 113.6364 KO $8,772.73
Commission     ($7)
Cap Gain Tax     ($564.86)
Commission     ($7)
Buy 115.41 PEP $8,193.87

Note that once again I "reverse adjusted" the KO holding to demonstrate that one is selling all of the Coca-Cola shares bought in 2003. There are two $7 commissions included and just over $560 in capital gains tax. Now the tax bit can be highly disputed. For example, in a Roth IRA or if someone doesn't make enough money this wouldn't exist. But assuming a taxable account and a person making enough money, this amount was calculated as 15% on the amount above the original cost basis. Furthermore this tax might change in the future but at present it is reasonable, although overstated for many, as a working proxy. We see that if one felt the inclination to sell their KO shares in lieu of a better opportunity, they wouldn't have the $8,770 of KO value to work with, but rather an amount of just less than $8,200. In this way, not only does your decision have to be better, but more aptly it has to be better by the applicable frictional and opportunity costs.

The interesting part about this is that PepsiCo still comes out ahead. 115.41 shares paying $2.15 a year turns out $248.13 in annual income; which is still above KO's $232 income number. This seems pretty attractive, given that one's holdings are now worth nearly $600 less on paper. To be frank, I was "rooting" for KO to come out ahead after transaction costs were accounted for. It seems that the opportunity costs of switching a low-yield dividend growth stock for a higher-yield one have been exaggerated. In fact the gap widens if you believe say Johnson & Johnson (NYSE:JNJ) and its 3.6% yield will outperform KO in dividend growth moving forward.

The apparent criticism is that there are reasons to hold a dividend growth stock other than pure income. And while this ideology appears to poke a bit at the common DG investor's mantra (including my own) of caring about the most income going forward, it is not exclusive from of our lasting realization. There are both conceptual and inherent reasons to hold a collection of dividend growth stocks. For example, one might diversify to alleviate the risk of a given security freezing or cutting their dividend. For that matter, it is overly difficult to predict if say Kimberly-Clark (NYSE:KMB) with a 3.5% yield will outperform the income generated by Target (NYSE:TGT) with a 2.2% yield moving forward.

However, this example at least provides a fundamental reasoning that suggests that one can move about dividend growth securities and still make more income, even after frictional expenses have been accounted for. I think many DG investor's are quick to assume "ok, I have a low cost basis, even if I wanted to sell the stock and buy something else the next best alternative, after expenses are considered, isn't going to be adding income". But we just saw that even a small yield differential and a low cost basis can't mitigate the power of a higher yield.

The final leg in evaluating the concept of "trading dividends" is opportunity cost. So far we have seen that there is a mathematical case for trading low yields for high yields. And while we might have some lower yields for diversification and safety purposes, knowing the math can illuminate the impact that these yields have on an income portfolio. Of course the mathematical assumptions are based on forecasts that cannot be known, but they aren't necessarily unrealistic. Nevertheless we have not yet considered the opportunity cost of trading say Coca-Cola for PepsiCo or for that matter Coca-Cola for Waste Management (NYSE:WM). It is true that one could likely gain more income by trading in your shares of Coca-Cola for a higher yield today. But consider that you bought Coca-Cola for a very specific purpose: you thought that Coca-Cola was attractive in both price and their ability to continue increasing payouts due to their undeniable brand strength.

So when you "trade in" shares of Coca-Cola you're not just trading in a given level of income, but more importantly you are trading in a partnership with a wonderful company. In order for the mathematical case to work out you would want to make sure that the two companies are equally wonderful; and this is where the opportunity cost comes in. Since you are unlikely to find many more Coca-Cola's, you at least want to be compensated in such a way that the additional income that you receive more than makes up for you agreeing to pay to exchange your wonderful ownership claim for a lesser one. For some, there is no price high enough. That is, no matter the extra income that could be generated, the opportunity cost of not partnering with wonderful companies is too great. Obviously this portion of costs is a bit more subjective, but they have an important place in the process nonetheless.

The overall point is that you can do the math and find that switching to a different dividend growth company is likely to produce more income; even after taking the relevant frictional costs into account. But if you're concerned about more than just income, for example - diversification, sleeping at night, having the chance to partner with a wonderful business - then the math doesn't tell the whole story. Personally, I find it compelling that more income doesn't automatically necessitate a better decision. The trick is quantifying your applicable opportunity costs.

Disclosure: I am long KO, PEP, WM, TGT, JNJ. 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.