First Published on December 30th, 2022 by Jonathan Weber for SureDividend
Many income investors operate with a buy-and-hold approach, which generally makes sense. This reduces transaction costs and means that investors don’t have to invest too much time trading in and out of individual equities. When one invests in high-quality dividend stocks, the buy-and-hold approach also oftentimes works out over long periods of time.
This is why we believe that the Dividend Kings are the best-of-the-best dividend paying stocks to own as these names have raised their dividend for a minimum of 50 consecutive years. You can see all 48 Dividend Kings here.
We have created a full list of all the Dividend Kings, along with important financial metrics such as price-to-earnings ratios and dividend yields. You can access the spreadsheet by clicking on the link below:
Still, there are cases when selling a dividend stock makes sense. In this article, we will explain our methodology when it comes to selling dividend stocks under certain conditions.
Three Scenarios Where Selling Dividend Stocks Makes Sense
At Sure Dividend, we prefer to invest with a long-term mindset, which is why we will oftentimes hold dividend-paying equities for long periods of time. But under some conditions, we are willing to sell dividend stocks.
1: Sell When A Dividend Is Overly Risky
Ideally, a company’s cash flows and earnings grow very reliably over time. When that happens, there is little risk that a company will be forced to cut the dividend, as coverage ratios improve when the dividend is held constant. Even if the dividend is growing over time as well, coverage can still remain constant when dividend growth and earnings or cash flow growth are relatively in line with each other.
But that is not always the case, as some companies experience trouble at times. When competitive pressures rise in an industry, or when an economic downturn hurts a particular industry or company especially hard, profits and cash flows can come under pressure for the affected companies. Not all companies are subject to this threat to a similar degree, as there are more resilient and less resilient companies. Still, many companies will experience earnings declines at some point, and that may result in a dividend cut.
Company-specific issues, such as lawsuits from consumers or competitors, or other problems such as growth projects not working out, can cause pressure on dividend coverage ratios as well. We like to watch the earnings and cash flow payout ratios of companies in order to identify potential dividend cut risks before the dividend cut is announced.
When a company’s earnings or cash flow payout ratio is high and when there is an upwards trend, i.e. when dividend coverage is not improving but getting worse, there is considerable risk that the company will reduce or eliminate its dividend eventually. Selling before that dividend reduction can make sense, as it may allow investors to exit a position at a still-good share price.
Selling once the dividend reduction has been announced may be a worse idea, as other income investors will likely sell the stock at that point as well, meaning one receives a lower settlement for selling shares once the dividend reduction has been made official. Being ahead of the herd by selling when it looks like a dividend is very risky thus is a prudent idea.
An example for that is oil supermajor BP (BP), which suspended its dividend following the 2010 Deepwater Horizon oil spill. The following chart shows what happened after the dividend was cut:
Source: dividend.com
The company made its last dividend payment in March 2010, at A. Shortly thereafter, at B, the Deepwater Horizon accident occurred. At that point, it was relatively obvious that BP would have problems in the near term and that the dividend would be at risk. Those that sold quickly following that news still got a solid price for their shares, around $50. Later that year, at point C in the above chart, BP officially suspended its dividend. Those that sold at that point got a much lower cash value per share relative to those that sold their shares when it became clear that the dividend would be at risk immediately following the Deepwater Horizon news.
These sales of at-risk stocks could be called preemptive sales. Of course, there’s always some likelihood that these companies will not cut their dividends, but even if that is the case, investors may benefit from moving their funds towards higher-quality names with better dividend coverage. Higher dividend growth potential and peace of mind can be some of the advantages of moving out of at-risk stocks.
2: Sell When The Dividend Has Been Cut
Ideally investors can identify a potential dividend cut ahead of time and react with a preemptive sale, but that does not always work out. Sometimes, the market and the investor community are surprised by a dividend cut, e.g. when coverage ratios of the company’s dividend still looked solid prior to the dividend cut announcement. That can happen as part of a broader change in strategy, or when M&A actions are announced.
One example of that is AT&T’s (T) decision to cut its dividend following the merger of its media business with that of Discovery. This merger created a new company, Time Warner Discovery (WBD), which owns a wide range of media assets. Since AT&T itself is no longer retaining a stake in the new company, its earnings base and cash flow generation potential diminished, which is why the company reduced its dividend. That was announced as part of the merger and spin-off announcement, thus investors didn’t have time for a preemptive sale.
Prior to the deal with Discovery, AT&T’s dividend coverage wasn’t extraordinary, but solid — the company paid out around 60% of its net profits via dividends. Many investors did thus not anticipate a dividend cut, as the dividend didn’t look especially risky before the merger and following spin-off of the two companies’ media businesses.
Immediately following the news of the dividend reduction, AT&T’s share price started to decline. Those that sold directly following the announcement still received $17 per share. Over the following months, AT&T’s share price continued to decline, eventually hitting a low of just $13 per share, more than 20% below where the share price stood directly after the dividend reduction announcement. Selling once this news became public would thus have worked relatively well, as it would have prevented investors from seeing their principal erode further over the following months.
3: Sell When Expected Total Returns Are Low
Many income investors focus on the dividends that their portfolios generate. While that makes sense to some degree, total return shouldn’t be ignored completely. Even high-quality income stocks can be too expensive at times, which increases the risk of share price declines in the following months and years. Looking at a stock’s total return potential, i.e. the combination of its dividend yield and share price appreciation (or depreciation) potential, makes sense, we believe.
At Sure Dividend, we generally recommend buying stocks with forecasted total returns of 10% and more per year over a 5-year time frame. At the same time, we believe that selling equities with forecasted total returns of less than 3% is a good idea, with those in between those two levels being rated as “holds”. Some adjustments can be made based on a company’s individual quality and track record, but those levels are suitable as a rule of thumb.
One example where selling based on this rule worked out well is Microsoft (MSFT). Microsoft is a high-quality company with a fortress balance sheet and a strong track record that has exposure to growth markets such as cloud computing. Microsoft also has increased its dividend for a compelling 20 years in a row, making it a reliable dividend growth investment. Add recession resilience and a low payout ratio, and the dividend is very safe on top of that.
And yet, even a high-quality company such as Microsoft isn’t a buy at all times, and it isn’t even a hold at all times. Depending on valuation, even a company such as Microsoft can be a stock that should be sold. Towards the end of 2021, Microsoft traded at a very elevated price per share of more than $340. At the same time, the company was forecasted to earn around $9 per share during that year (the actual result was slightly stronger, as earnings-per-share came in at $9.22 for the year).
At the peak, Microsoft thus was trading for a very elevated 38x forward expected earnings. Even for a quality company such as Microsoft, that’s a too-high valuation. Forecasted total returns at that point were slim, as we expected that multiple compression headwinds would mostly offset the expected positive impact from growing earnings-per-share. At the same time, the dividend yield was pretty low, at well below 1%, due to the elevated share price.
With forecasted total returns of less than 3%, Microsoft would have been a Sell at that point. And over the following year, it turned out that this would have been the correct decision:
Source: Seeking Alpha
Microsoft’s share price went down by close to 30% over the last year, which would have offset the dividend proceeds of many years for those that held on to shares at an elevated level.
With Microsoft now trading below $240 per share, the calculation looks very different. In our most recent update, written when Microsoft traded in the low $230s, we forecasted total returns of around 12% per year over the next five years. That made us give Microsoft a buy rating, as the combination of strong forecasted total returns and Microsoft’s quality metrics makes the stock attractive.
This example shows that income investors shouldn’t completely neglect a company’s total return outlook even when the dividend itself is safe. Moving out of overvalued stocks with low expected total returns in order to wait for a more opportune time to enter a position again can make a lot of sense. It reduces the risk of meaningful principal erosion, and it can increase one’s portfolio returns over time.
Final Thoughts
Buying quality income stocks that ideally grow their dividends reliably and holding onto them is a good strategy. But investors shouldn’t be adamant about owning the same stocks forever.
Under some conditions, selling dividend stocks makes sense, we believe. When a dividend cut is likely, when a dividend cut has been announced, and when forecasted total returns are weak, e.g. due to a too-high valuation, selling dividend stocks can be the right choice, even for income investors that generally follow a buy-and-hold approach.
This article was first published by Jonathan Weber for Sure Dividend
Sure dividend helps individual investors build high-quality dividend growth portfolios for the long run. The goal is financial freedom through an investment portfolio that pays rising dividend income over time. To this end, Sure Dividend provides a great deal of free information.
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