In the last Lesson, we talked about buying dividend growth stocks. We learned about quality, valuation, and how to make sound buying decisions.
For many investors, buying is the easy part. It is much harder to decide whether to hold or to sell – those are harder decisions.
Why? Because when you are buying, you have done all the investigation and research, and you are ready to go. Buying is an action, and it is human nature to take action. That is what most of us are wired to do. Some investors have great difficulty keeping their hands off their portfolios, wanting constantly to tinker with them.[ad#Google Adsense 336×280-IA]But in investing, sometimes taking action is the wrong thing to do.
Studies have shown that most investors underperform the very securities that they invest in.
How is this possible?
Because they trade too much.
The field of behavioral finance has demonstrated that many investors trade at the wrong times.
They sell, emotionally, when prices are falling. By selling, they often lock in a loss.
Having sold, they wait too long to buy back in (because they have fear of the market), and thus they miss some gains that the actual securities make. When they finally decide to get back in, they are too late. They may pay a higher price to get back in than the price at which they sold.
Thus they underperform the security that they invested in. They would have been better off leaving it alone. Their emotional reaction to price changes ends up costing them money.
Dividend Growth Investing Can Help
In the last Lesson, I stated that dividend growth investing is largely about buying excellent companies and holding onto them.
Unlike other styles of investing, dividend growth investing is not about buying low and selling high. You are not trying to make money by “flipping” the stocks.
Dividend growth investing is more about buying low and then, in the ideal case, never selling.
You are a collector. First you collect shares of stock. You collect ever-rising streams of dividends from the companies that you own. Then you reinvest those dividends to buy more shares of stock, and then you collect dividends from them too.
You make money from the flow of dividends, not by flipping the shares.
This kind of stock investing is like being a landlord. A landlord buys properties so that he can rent them out. Over the long term, he makes money by collecting rents.
Dividends are like rents. You collect them. The key is that a landlord is not intending to sell the property that he owns. If he were to sell his properties, he would lose his ability to collect rents. He would have to decide what to do next.
Dividend growth investing is similar. You are not buying stocks with the intent of selling them for a profit. Don’t get me wrong, as life turns out, you will sell some of your stocks. But that is not your intent when you buy them.
Your intent is to hold onto them and collect the dividends. As Warren Buffett has said, “When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”
OK. Let’s presume that you have read the previous lessons in this series, plus other terrific articles on Daily Trade Alert, and that you have built a portfolio of great dividend growth companies.
You are collecting the dividends and reinvesting them to build your portfolio even larger. Or maybe you are retired and you just spend the dividends. Either way, why might you consider selling anything?
That’s what we will explore in the remainder of this article.
Treat Selling in Your Business Plan
You have a business plan, right? We talked about business plans in Lesson 12 Part 1 and Part 2, as well as in Lesson 13. In my opinion, every serious investor should have a business plan.
Your business plan should contain guidelines for when you will consider selling a dividend growth stock.
Why? Because we always strive to make our investing activities rational. We don’t want to sell in a panic, churning our accounts and overtrading. That is self-defeating behavior.
So as we talk about reasons to consider selling in the remainder of this article, consider incorporating the concepts that make sense to you as guidelines in your own business plan. That’s what I have done.
Reasons to Consider Selling
Go back to our basic business model: As a dividend growth investor, your goal is to collect, over time, stocks that pay a rising stream of dividends. Your end-game is to live off those dividends when you retire.
But there will be times when selling something that you already own advances your business model better than just continuing to hold it. Here are a few suggestions for situations when you might consider selling.
A stock cuts, freezes, or suspends its dividend.
The logic here is obvious. Your goal is to collect stocks that, together, give you a reliably increasing stream of dividends. If one of your stocks cuts its dividend, or suspends its dividend program, it is not a “dividend growth” stock any more.
Famous examples of such stocks include the many financial stocks – banks – that cut their dividends in the financial crisis of 2008-2009. I owned a couple, and I sold them. In some cases, such stocks have recovered, but in other cases they have not.
Most people don’t think of General Electric (GE) as a bank, but in 2008, its profits were dominated by its financial division. That division got hammered, and GE cut its dividend in 2009.
Check out the light gray line on this graph. That is GE’s dividend. Notice the severe cut in 2009. That’s when I sold GE. Unfortunately, in this case, major price damage had already occurred, as shown by the black price line, so I sold it at a loss.
But that was not the reason to sell. The sale was not made in fear of further loss. The reason to sell was the dividend cut. The reduced dividend was inconsistent with my goal, which is to have increasing dividends.
Notice that, 6 years later, GE’s dividend has not recovered to the level it paid in 2008. Nor has its price recovered either, during an era when the stock market has doubled. Not only that, GE announced earlier this year that it would freeze its dividend for 2015 and 2016.
As I look back on that decision from the perspective of 6 years, it was exactly the right thing to do given my goals.
One of your stocks bubbles or becomes seriously overvalued.
I discussed how I value stocks in Lesson 11. In my Dividend Growth Stock of the Month articles, I summarize valuation in a table like this.
But what if the valuation summary looked like this?
Even though your business goal is to collect an ever-rising stream of dividends, you would have to consider selling or trimming in a case like this. Especially if you had an alternative company to invest in that was fairly valued and paying a larger yield. You could increase your income flow instantly by making the swap.
This is something that I do seldom, but I will do it. One way to look at it is that you may collect in profits the equivalent of several years’ worth of dividends by selling. If you can turn around and invest that money into a better-valued stock with a much better yield, you have to seriously consider doing it.
I recently faced just such a decision with Hasbro (HAS). Its valuation is way up. Its price is a two-bagger for me, not even counting the dividends I have collected.
In this instance, I decided not to sell or trim Hasbro, but it was a close call.
The deciding factors for me were these:
• Hasbro’s proportion of my portfolio is 5%. I allow a position to be 10% before I consider the position to be “too large.”
• Its business is strong.
• Estimates going forward are strong: Analysts estimate 3-5 year earnings growth of 11.5% per year.
• I see nothing qualitatively or subjectively troubling about the business. Morningstar awards it a narrow moat rating. Its credit rating is BBB from S&P and BBB+ from Morningstar, both of which are considered “investment grade.” S&P Capital IQ’s quality grade is A, which is second from the top rating.
• The company raised its dividend 7% in May. That is a solid sign from management. “The safest dividend is one that has just been raised.”
• Its 5-year dividend growth rate is 16% per year.
In other words, Hasbro is doing exactly what I bought it for. So I decided to stick with it. I look forward to at least several more years of good dividend increases. For all I know, Hasbro could eventually become a Dividend Champion. At the moment, it has increased its dividend payout for 12 straight years. It is about halfway to becoming a Champion.
The point is, Hasbro’s valuation caused me to seriously consider selling it. It caused me to do the analysis that I just described.
Importantly, from a psychological point of view, I took action. The action was not to sell Hasbro, but rather the action was to make a decision. Deciding to hold is a decision.
That’s why I titled this Lesson “Holding and Selling.” I want to emphasize the idea that making an active decision to hold is a decision. That is different from just doing nothing.
Obviously, someone could reach the same result by paying no attention at all, and indeed some advisors advocate that.
I do not. I don’t see an upside to deliberate ignorance of facts when it comes to investing. Those who advocate willful ignorance do so, I believe, because they think that the average investor will panic or have some other self-defeating emotional reaction to certain facts.
Don’t be that investor. Approach your investing like a business. Gather the facts and make sound decisions. Emotions really should have nothing to do with it.
A position’s size increases beyond the maximum size that you have selected for your portfolio.
In my Dividend Growth Portfolio (DGP), I have decided that no position shall exceed 10% of the whole portfolio. In the monthly update of the DGP, I display the position sizes. When I prepare that update each month, I notice whether any positions are too large.
Actually, many dividend growth investors do not tolerate position sizes as large as 10%. From reading articles and comments around the Web, I have learned that many dividend growth investors prefer to hold maximum position sizes of 5%, 4%, 3%, or even 2% of their portfolios.
Notice that as you reduce your maximum position size, you must by simple math increase the number of stocks in your portfolio.
I consider the choice of maximum position size and number of stocks to be a personal decision. Obviously, the more stocks that you own, the less damage any one of them can cause if it blows up. That is an obvious risk-mitigation tool that many investors employ.
On the other hand, the more stocks that you own, the more there is to keep track of. The less benefit you will get if any one of them does really well.
My choices have become:
• Maximum position size = 10% of portfolio
• Target number of stocks = 20-25
A more common approach would be something like this:
• Maximum position size = 4% of the portfolio
• Target number of stocks = 25-30
Earlier this year, I did some trimming in my DGP expressly based on this factor of maximum position size. What I did is described in this article: “Why I Sold Some Johnson & Johnson (JNJ) and Pepsi (PEP).” In a nutshell, JNJ and PEP had both become oversized (more than 12% of the portfolio), and so I decided (there’s that active verb again) to redress that situation. Here is what I did:
• Trimmed JNJ and PEP each back to 9% of the portfolio to get them under the 10%-max guideline
• With the proceeds, added to existing positions in AT&T (T) and Microsoft (MSFT)
• With the remaining proceeds, started a new position in Digital Realty Trust (DLR)
Thus, this package of trades served several strategic goals at the same time:
• It corrected the over-sized positions by getting them back under 10% of the portfolio
• It allowed me to increase my stakes in two high-quality dividend growth companies
• It allowed me to add a new position, bringing me closer to my target of 20-25 stocks overall.
The company’s dividend growth rate (DGR) is in decline
In David Fish’s Dividend Champions list, you will find some companies with declining dividend growth rates over the past 10 years.
In this example, we can see that APD’s DGR has dropped from 11.2% per year for the past 10 years to 9.0% for last year, and that their most recent increase was just over 5%. The declining pattern is uninterrupted: Each shorter period shows a lower growth rate than every longer period.
As an owner, you could decide that APD is not the dividend grower that it once was, and that maybe your investment dollars would produce better results elsewhere. Obviously, this is a personal decision. APD is still a dividend growth stock (indeed it is a Champion with 33 straight years of higher dividends), so the declining rate of annual growth may not be something that you are worried about.
I have highlighted four reasons to consider selling above. You should also consider other reasons that make sense to you. Here are a couple of other selling guidelines for your consideration.
• You receive news of significant changes impacting the company. Examples could be that it is going to be acquired; or it announces plans to split itself into two or more companies; or it announces plans to spin off a separate company.
• Its current yield rises above 9 percent or drops below 2.5 percent. I have this guideline in my own business plan. The idea is that at 2.5% or less yield, the company is not paying me enough, or that at 9%+ something risky is going on that I ought to investigate. Sound reliable companies normally do not have yields over 9% in this day and age.
Guidelines, Not Rules
When I first began as a dividend growth investor, I treated my selling guidelines as automatic rules. For example, if a company froze its dividend, I automatically sold it.
I have since decided that I should consider these to be guidelines rather than rules. The way I word them is, “Seriously consider selling or trimming if….”
The reason is that sometimes you may have a situation where the best decision, all things considered, is to hold.
For example, during weak economic times, a company may temporarily freeze its dividend. Many companies did that in 2008-09, and it was a prudent move. Then after the economic crisis and recession passed, they resumed their annual dividend increases. Obviously, such situations would require case-by-case analysis.
The example above with APD’s long-term declining growth rate could be one where you notice it, investigate it, and in the end decide that APD is doing just fine, so don’t do anything.
In my business plan, the language “seriously consider selling” is carefully chosen. Even if a stock freezes its dividend, I want the flexibility not to sell it. Maybe the company has a good reason, and it is clear that dividend increases will resume shortly.
Key Takeaways from this Lesson
1. Deciding whether and when to sell is often more difficult than deciding what and when to buy.
2. Many investors shoot themselves in the foot by trading too much. Don’t be that guy.
3. Dividend growth investing can help guard against over-trading, because you are mostly watching dividends that grow rather than prices that hop all over the place. You are less likely to react emotionally if you keep your eye on the steady income flow from dividend growth stocks instead of volatile market prices.
4. Dividend growth portfolios normally do not have a great deal of turnover. You are a collector of income-producing stocks rather than a trader.
5. Nevertheless, there will be instances where the best thing to do to reach your long-range goals is to sell or trim a position rather than hold onto it. You should spell out your selling guidelines in your business plan. Then you can consult your plan to remind yourself of how you analyzed these issues when you were calm rather than just reacting when a situation pops up.
6. Both selling and holding are active decisions that you make. Holding is a decision.
7. Reasons to consider selling or trimming a position include:
• A company freezes, cuts, or suspends its dividend.
• One of your stocks becomes far overvalued, and you have reasonable alternatives for your money that would allow you to take advantage of your unexpected profits.
• A position becomes too large for your portfolio, increasing its overall risk.
• A company’s dividend growth rate is in a long-term, uninterrupted decline.
• Something significant and fundamental is changing for the company.
• The company’s current yield falls to a very low percentage (perhaps no longer delivering the amount of income that you want from that stock) or climbs to a very high percentage (suggesting that the dividend is in danger).
Dave Van Knapp