Published on February 6th, 2015
- When to sell dividend stocks is an often overlooked part of investing
- There are two primary reasons to sell dividend stocks
- See The Sell Rules of The 8 Rules of Dividend Investing
The vast majority of financial and investing literature discusses what and when to buy and how to build and your portfolio. The topic of when to sell is discussed much less. I believe this is because buying stocks is exciting. We think about how much money we can make in an investment, or how the dividend payments will grow. When you sell a stock it is either because you believe there is a better investment available elsewhere, or you need to use the money tied up in the investment for another purpose. This is decidedly less exciting than the prospects of making money buying a new stock. This article discusses when to sell dividend stocks using The 8 Rules of Dividend Investing.
Two Reasons to Sell Dividend Stocks
Rules 6 & 7 The 8 Rules of Dividend Investing discuss specifically when to sell a dividend stock. Rule 6 is called “The Overpriced Rule”. As you may have guessed, it applies to stocks that are trading far above fair value. Rule 8 is called “The Survival of The Fittest Rule”. This rule applies to stocks that are in danger of losing or have lost their competitive advantage and are no longer able to maintain dividend payments. Each of the two sell rules are discussed in detail below.
Sell Rule 1: The Overpriced Rule
The first Sure Dividend sell rule is to sell dividend stocks with a normalized price-to-earnings ratio above 40. Stocks with high price-to-earnings ratios have historically significantly underperformed stocks with low price-to-earnings ratios. The image below shows the performance of high price-to-earnings stocks versus low price-to-earnings stocks over a 35 year period.
The highest priced stocks have significantly underperformed the market. The normalized price-to-earnings ratio of 40 is used as a cut-off because that is the peak (or very close to it) valuation that the entire S&P 500 has reached. A dividend stock with a price-to-earnings ratio of 40 is extremely likely to be overvalued.
It is important to use normalized earnings rather than GAAP earnings. You do not want to sell a stock that has a price-to-earnings ratio of 40 because earnings are depressed 50% due to a one-time event. Additionally, it would not be smart to sell a highly cyclical stock because it has a high price-to-earnings ratio due to depressed earnings from its cyclical trough.
The Overpriced Rule moves investment funds from overpriced dividend stocks and into fair-value-or-better dividend stocks that are more likely to reward investors with both price and dividend growth going forward.
Sell Rule 2: The Survival of The Fittest Rule
The second Sure Dividend sell rule is to sell stocks that have cut or eliminated their dividend payments. Dividend stocks that have cut or eliminated their dividend payments have either temporarily or permanently impaired investor dividend income. The purpose of owning high quality dividend growth stocks is to see your dividend income steadily grow through time. When a dividend stock cuts or eliminates its dividend payments, it violates the reason for owning the stock.
Businesses that cut or reduce dividend payments send a very clear signal to investors. They are showing that they are not confident the business can maintain its current cash flows. This generally means the company’s competitive advantage has either weakened or been lost completely. In either case, your investment dollars should be reinvested into a higher quality businesses that will grow dividend payments regularly.
The argument against owning stock that have cut or reduced their dividend is supported by the historical record. Over a 40+ year period ending in 2013, stocks that cut or reduced their dividend generated an average return of 0%. Dividend stocks that reduce or eliminate their money provided no returns. It is better to hold cash in an interest bearing bank account than to own stocks that have cut or reduced their dividend payments. The image below shows how dividend growth stocks have substantially outperformed stocks that cut or reduce their dividend payments.
In a perfect world, you would never have to sell any dividend growth stocks. Your stocks would continue to pay increasing dividends year-in-and-year-out. Unfortunately, neither you nor I can tell the future. We will both occasionally invest in stocks that do reduce or eliminate their dividend payments or become substantially overvalued. In either case, it is best to reinvest proceeds into fairly valued or undervalued high quality dividend growth stocks that will reward you with rising dividend payments on a regular basis.
Selling an overalvalued dividend stock and buying an undervalued dividend stock will likely increase the dividend yield of your portfolio. Even a stock with a 100% payout ratio will have just a 2.5% dividend yield if it’s price-to-earnings ratio is 40. Alternatively, an undervalued stock will likely have a higher dividend yield. The lower a dividend stock’s price, the higher its dividend yield, all things being equal.
Selling a dividend stock that has cut or eliminated its dividend will likely increase the future dividend growth rate of your portfolio. Dividend cutters and eliminators cannot be counted on to grow their dividends in the future. By selling a dividend stock that has cut or eliminated its dividends and reinvesting the proceeds in a stock that exhibits solid dividend growth, you will raise the expected dividend growth rate of your overall portfolio.
Investors who have a predefined plan for selling stocks will be able to execute their plan when the time comes. Those who do not have a predefined plan may sell prematurely or find themselves being tempted to ‘hold on a little longer’ in hopes that a dividend reducer turns its operations around. Predefined sell rules prevent panic selling and give clear and concise instructions on when to sell, giving investors clarity and confidence in their selling decisions.