Some of us think holding on makes us strong, but sometimes it is letting go" - Herman Hesse
Herman Hesse was a German poet, novelist, and painter. He received the Nobel Prize of literature in 1946. To the best of my knowledge, he wasn't that concerned with the stock market. However, had he approached it with the philosophy which transpires in the quotation above, he probably would have done quite well.
Everybody who invests in the stock market has rules which he follows to buy stocks. Ask anybody on Seeking Alpha what they look for when purchasing stocks, most of them will have a clear answer.
Safe dividend stocks with an appealing combination of dividend yield and dividend growth potential whose share prices are likely to increase."
It might sound vague, but it is the backbone of all our equity analysis articles. We look at dividend safety, then dividend potential, then the stock's potential for capital appreciation.
But for many, less thought goes into when to sell a stock. Some investors even bypass the question altogether claiming they will "buy and hold forever".
In this article, I will attempt to give a framework for when dividend investors should sell their shares.
As far as I'm concerned, there are three reasons dividend investors should sell their dividend stocks:
This article will focus on reason number 3: when the stock has become overvalued.
As a fervent value investor, I have always believed in buying dimes for a nickel. Graham & Dodd led the way with value investing, Warren Buffett followed suit and made it accepted worldwide as a sensible way of investing.
Nobody will ever tell you that buying undervalued stocks is a bad idea.
But here is the rub. To realize value, you need to sell the shares.
By now, you might know that we're big fans of the work James O'Shaughnessy performed on factor investing in his book "What Works On Wall Street'. His son Patrick O'Shaughnessy, who is now the CFO of OSAM research has continued his work.
His team regularly posts on their company's blog. One of my favorite pieces is "factors from scratch", where the authors break down the value factor and what has contributed to it outperforming the market.
It's a rather long read, but the key takeaways are important.
To understand the ramifications, it is first important to understand how researchers create "value" indices to test the factor. The following will explain why researchers usually find that over long periods of time, value stocks beat overvalued stocks, and also beat the index, like the S&P 500 (SPY).
First, all equities need to be ranked from the most undervalued to the least undervalued. The methodology can vary from one researcher to the next, the one used by OSAM is very similar to the value score we use in our articles. You can read more about our methodology by reading this blog post.
The stocks are then put into quintiles or deciles, from most undervalued to most overvalued. Researchers will then test the performance of an equally weighted portfolio which contains all the stocks in a given quintile. This portfolio will be rebalanced at an arbitrary date. The stocks which are no longer in the quintile get sold, the ones which make its way in getting purchased and the portfolio is rebalanced to start over with an equally weighted portfolio.
And this is where it gets interesting:
When you purchase a basket of stocks: its return can be broken down into earnings per share growth, dividends, and PE multiple expansion.
For research purposes, we can convert dividends into buybacks ( a similar effect to reinvesting dividends), which would then leave us with EPS growth and PE multiple expansion.
If the EPS goes up but the price stays the same, by definition the PE goes down. If EPS stays the same but the price goes down, by definition the PE goes up.
Let's illustrate this with an example.
You buy one share of a $10 stock with a P/E of 10x, so EPS of $1. You hold it for a year, during which EPS declines 10% to $0.9, but the price increases to $15. Your total return is 50%.
You sell your share and purchase a different $15 stock with a P/E of 10x, so you get one share with an EPS of $1.5.
By rebalancing, you go from $0.9 in EPS to $1.5. We can, therefore, identify two dynamics: holding EPS growth and rebalancing EPS growth.
Why is this important?
Comparing the most undervalued quintile of stocks ( called Value) to the most overvalued quintile ( called Glamour) between 1964 and 2017, if you rebalanced every year, Value would beat glamour by 4.8% per annum.
But if instead of rebalancing once a year, you rebalanced only every 10 years, Value would only beat Glamour by 1.65%
This happens because value stocks don't remain undervalued forever.
Stocks often go from fairly valued to undervalued back to fairly valued up to overvalued back to fairly valued.
Most of the time, stocks are fairly valued. Occasionally, they will become undervalued. At that point, their future returns will usually be higher. Occasionally, they will become overvalued. At that point, their future returns will be lower. Once they go back to their normal valuation, their future returns can be expected to be normal.
Key Takeaway: If you don't realize value, there is little point in purchasing undervalued stocks.
Dividend investors might be thinking at this point: "But this doesn't apply to me, I'm investing for dividends not capital appreciation".
It's time to shift your mindset. I often say that dividend investors should focus on achieving maximum total returns, with the caveat that the dividend must contribute significantly to those returns.
Capital gains are your insurance against low dividend growth. Say you read this article we wrote and figured out that for you to meet your financial goals by investing in 3% yielding stocks, you need the dividend to grow at 7% per year.
By the end of the year, you realize management only increased the dividend by 5%. At this rate, you'll be retiring a lot later than you initially hoped…
The stock appreciated 50% in the meantime. The dividend yield is now 2.1%. If you had invested $100,000, this would mean $3,150 in annual dividends. Yet, for you to meet your goals, you should have made $3,210. A minor difference, but one that will compound hugely over multiple years.
Remember I said, "capital gains are your insurance against low dividend growth".
The beauty of dividend investing is there is always another stock to buy. At any given time, there is always a good buy. Let's say you have your eye on another stock, which yields 3%.
You could sell your $150,000 worth of the first stock and pour the proceeds into that new stock. For the next year, your income will be $4,500. A significant step up from the $3,150 you made.
By accurately picking undervalued stocks which subsequently go up in price, and by rebalancing into newly undervalued stocks, you can increase your dividend income a lot higher than if you were to follow a simple buy and hold strategy.
Key Takeaway: By realizing value, dividend investors can substantially increase their dividend income.
Yes… that is true, for simplicity, they weren't mentioned in the above section.
But it doesn't change anything about the way you think about it.
Only you can no longer look at your stocks dividend yield and compare it to other dividend yields to decide whether or not there are opportunities to increase your income.
You now have to look at what we call "yield on after tax proceeds from sale" (not an eloquent name, if you have a suggestion for a better name please drop it in the comments).
If you were going to pay 30% in capital gains on your position, in the example before, your initial investment would have a "yield on after tax proceeds from sale" of:
$3150/($150K - $100k) * (1 - 30%) + $100K = 2.3%.
What this means is that by selling your position, to replace your income entirely, you'd need to find a stock which yields at least 2.3%.
In the example above, you found a good looking stock which yields 3%.
Your after tax proceeds would be $130,000, which would yield you $3,900 in annual income at 3%. Still a handsome increase from the initial $3,150 you were getting.
Key takeaway: If there is a better opportunity, pay the taxman and realize the value, you can still increase your dividend income.
By realizing value, rather than buying and holding stocks, your dividend income could skyrocket way beyond your expectations.
Obviously, all your stocks won't go up 50%, some might even lose money, but if you focus on buying high-quality dividend stocks when they are undervalued and show signs of momentum, you should fare extremely well overall.
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