This is a guest contribution from Alan Wagner at Dividend Power. Dividend Power helps individual investors build life changing wealth through dividend growth strategies and unique screening capabilities.
Selling a stock is a challenging and often emotional endeavor. A decision that is more difficult than buying the initial position. The primary difference being that when we sell a position we’ve likely either made some gains, or we’ve lost. This is why the decision to cut ties with an existing position can be one of the more stressful times in your investing lifecycle.
Ensure that you are analyzing the proper metrics and your approach is planned with a long-term vision.
Tax Sheltered Account?
One of the first items you’ll want to consider is whether the position is in a tax sheltered account such as an IRA or SEP. This is important because you can sell positions without a taxable event taking place. Gains that you would normally pay taxes on are not paid when you sell the position, but rather when you withdraw the funds from the account itself. This certainly makes it much easier to move a position inside the tax sheltered account with no tax consequences.
Keep in mind the opposite is true for positions not part of a tax sheltered account. Selling any position with gains is going to create a taxable event. If the position was owned for less than one-year it will be taxed as ordinary income vs. capital gains. Any stock position that is owned for longer than one year is given tax benefits and categorized as capital gains. Be sure to fully understand how long you have owned your stock position and any tax consequences related to selling.
You also should be mindful of any other positions you have closed within the same tax year. We are able to offset any gains or losses in the same year. If you’ve encountered a big loss earlier in the year, you can sell a big gain to offset any taxes that would normally be liable for.
As a long-term dividend investor there really should be one reason why you would ever close a position. That one reason is all related to “the sustainability of the dividend”. The primary focus is to ensure that the company is able to sustain a plentiful dividend; one that will consistently grow annually.
We do this by selecting great companies with a competitive advantage. A company with a competitive advantage in the market will generate a healthy cash flow to sustain the dividend for years to come.
One of the metrics to determine if a company is at risk of cutting the dividend is the “payout ratio”. The payout ratio is a key financial metric used to determine the sustainability of a company’s dividend payments. A lower payout ratio is generally preferable to a higher payout ratio.
The payout ratio should also be cross referenced to other stocks within the same sector or industry. For example Real Estate Investment Trust (REIT) stocks typically have larger payout ratios and should be handled differently regarding payout ratios.
I recommend you monitor your positions for payout ratios over 65%. This does not mean that we jump to any rash decisions and sell any position approaching this threshold, but rather use it as an indicator to investigate.
Investigate the reason why the payout ratio has grown to its current state. Is sales revenue decreasing? Have margins deteriorated due to loss of competitive advantages? These are the type of questions you should be asking yourself to ensure the company you once thought was great, still is great!
Once you understand fundamentally why the company is sitting on a large payout ratio you’ll have a better understanding if the dividends can be sustained.
Money better elsewhere?
Let’s assume that we’ve already sold out positions for just a moment. Ask yourself where you would put your money now if you had the additional funds. Hopefully you have a Dividend Power Watchlist of great looking dividend stocks that are being sold at a fair value. Check out how to screen the market for additional details on finding great Dividend Growth stocks.
If you’re struggling to find a new position with that money than maybe it’s not time to sell. Given the market conditions you may be facing your current position might just turn out to be the best place for your money to stay.
Selling a stock position is a difficult decision within the investment lifecycle. Ensure that your decision has been well thought out and you fully understand any tax consequences of the event. Keep an eye on key cash flow metrics including the payout ratio to help ensure the company is able to provide sustainable dividends to shareholders. Put together a plan of not only why you sold the position, but why you’re buying your next position. Every decision to sell will be unique. Analyze your decision with the key items above to help ensure your portfolio is able to provide future dividends.
Notice we never mentioned the current market price. That is because in most cases, it shouldn’t even really factor into your decision. The market is volatile and short term sided, and we are not in this to play the market. Our focus is solely on the growing dividend. Be vigilant with your positions.