In my Dividend Growth Portfolio (DGP), I have 7 selling guidelines. Two of them are to investigate and seriously consider selling if:
• A stock becomes seriously overvalued.
• Its size increases beyond 10% of the portfolio.
The purpose of these guidelines is to reduce risk. If a stock is way overvalued, chances are that its price is going to drop or its rate of growth is going to slow. And if its size becomes more than 10% of the whole portfolio, you may have too many eggs in one basket.
These are guidelines, not hard-and-fast rules. So when conditions like these arise, my practice is to take a little time to investigate and decide whether to trim the over-size position and move the sale proceeds into another stock.
The stock is Realty Income (O).
Realty Income has been one of my most successful investments.
I bought it in 2008, twice, during the depths of the Great Recession.
Like many companies, O was on sale then, because investors were fleeing the stock market.
The market was crashing.
For a value-conscious dividend growth investor, that is the time to go shopping, not fleeing. You kind of edge your way into the door to avoid being trampled by everyone running out.
After my two purchases of Realty Income, I have simply held the shares for more than 7 years. Averaging the two purchases, I have a capital gain (price only) of 147% and yield on cost of 10.5%.
But because O’s price has gone up so much, it grew to comprise 11.7% of my portfolio’s value. That triggers the 10%-max guideline.
And at its current price of about $62, I reckon that Realty Income is about 32% overvalued. That triggers the valuation guideline. Here is the valuation summary. Remember that O’s actual price was about $62.
Realty Income’s overvaluation is the result of its price rising much faster than its earnings. Because yield and price move in opposite directions, O’s price rise has caused its yield to plunge.
O’s forward (indicated) yield is 3.8%. While that does not trigger yet a third selling guideline (yield dropping below 2.5%), it is a weak yield for a REIT. At fair value, O’s yield would be around 5%. O’s 5-year average yield (per Morningstar) has been 4.8%, so its current yield is 21% below what it would be if the stock were fairly valued.
Here’s another thing. O currently pays out about $2.39 per year per share in dividends. My calculations show that it is $15 overvalued. That means that the overvaluation is equal to more than 6 years worth of dividends. By selling, I can receive 72 months in dividends all at once from the overvalued portion of the price alone.
So I decided that, if I could find a worthy replacement, I would trim some O – in effect, taking some unexpected profits in cash – and use the “windfall” to invest in the replacement.
I found that replacement, which I wrote up as this month’s Dividend Growth Stock of the Month. The replacement stock is Ventas (VTR), a healthcare REIT in which I already held a small position.
Here’s the tale of the tape between the two companies.
So you can see that by making a swap:
• The money stays in the same sector (real estate)
• I move some money from being seriously overvalued to being nicely undervalued
• The yield on that money moves up from 3.8% to 5.3%
• I may be looking at faster dividend growth (although the future is never guaranteed)
• I am reducing risk from being so concentrated in Realty Income
• I may be adding a little risk by going down a bit in company quality
I decided to make the switch. So on April 5, I did the following:
1. Sold 48 shares of Realty Income for proceeds of $2991.
2. Bought 47 shares of Ventas at cost of $2977.
3. Left the extra cash ($14) in the kitty for dividend reinvestment.
Here is the expected impact on my portfolio.
As you can see, I achieved my immediate goals of having Realty Income drop below 10% of the portfolio and also to have less money invested in a seriously overvalued stock. Both of my selling guidelines have been satisfied. In addition, my expected annual income increases by $44, boosting the whole portfolio’s income by about 0.1%. I “bought more income” with the overvalued dollars.
Realty Income remains a relatively large position, still at more than 8% of the portfolio. The two transactions cost $20 at E-Trade (all figures above are net of those fees).
The bottom line is that I reduced my exposure to an overvalued stock, increased my investment in an undervalued stock with a better yield, and gave a small immediate boost to my expected income.
Please note that the facts that I have a big gain or large yield on cost do not enter into the question. In an article in 2012, I explained that yield on cost is not relevant when considering a sale.
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.
Likewise, the 147% capital gain in Realty Income is good news but old news. The stock’s past performance does not enter into the decision whether to trim it now. The trimming decision looks forward.
For a complete discussion of the reasoning behind decisions to sell from a dividend growth portfolio, please see Dividend Growth Investing Lesson 15: Holding and Selling.
– Dave Van Knapp
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