Wednesday, May 16, 2012

Replacing appreciated investments with higher yielding stocks

In my entry criteria, I look for great stocks with sustainable dividend payout, long histories of dividend growth and strong competitive advantages. I also have a minimum entry yield of 2.5%. There come times however, when the company I own keeps increasing its earnings and dividends, but the stock price rises faster than fundamentals. As a result, while my yield on cost is attractive, my current yield is less than my entry criteria.

For example, my yield on cost on W.W.Grainger (GWW) is 4%, whereas the current yield is 1.60%. My yield on cost on Family Dollar (FDO) is 3.40%, while the current yield is 1.20%. My yield on cost on Higham Institution for Savings (HIFS) is 3.60%, while the current yield is 2.20%.

The common characteristic behind these three positions is that each has delivered solid capital gains since my initial purchase.

Some investors question whether owning these stocks would make sense, given the low current yields that they are exhibiting. Replacing my positions in W.W.Grainger and Family Dollar with stocks which yield 3% currently would provide an almost doubling of my dividend income from each position.

This would be a mistake however, since nothing has fundamentally changed with these businesses. In addition, both companies have excellent growth prospects ahead of them, which will likely lead to further increases in earnings, dividends and stock prices over time. Stocks can deliver low current yields, even while the underlying business keeps growing. This will lead to a higher dividend income stream coupled with a solid potential for capital appreciation.

For example, current yields on certain quality stocks such as Procter & Gamble (PG) and Johnson & Johnson (JNJ) and Abbott (ABT) were low during the last few years of the 1990’s bull market. Investors who sold and purchased higher yielding shares would have most probably missed on the upside potential for both capital gains and dividend income. While adding to position which are overvalued might not be the best idea, holding onto these positions might be perfectly appropriate.

As a dividend investor, I expect to hold my holdings for as long as possible. This is until one of my exit rules kick in. I expect that at least several of my long term portfolio holdings will generate total returns of several hundred percent over the next decades. This will compensate for the ones that cut dividends or get bought out for example. By selling stocks simply because the current yield is low, I might risk reducing my long-term returns.

In addition, I am not a big fan of chasing yield. If I were actively replacing my income stocks with higher yielding ones, this would increase the risk to dividend income, as most higher yielding stocks have higher payout ratios. In addition, most of the higher yielding securities come from a concentrated number of sectors.

Full Disclosure: Long all stocks mentioned above

Relevant Articles:

- Margin of Safety in Dividends
- Build your own Berkshire with Dividend Paying Stocks
- Investors Get Paid For Holding Dividend Stocks
- When can you retire on dividends?

6 comments:

  1. DGI, I'd just like to check: you say it wouldn't make sense to switch to a higher-yielding stock (at say 3%) because the fundamentals haven't changed.

    What if you switched it with another higher-yielding stock whose fundamentals also haent changed? eg from GWW to JNJ?

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  2. I'd agree that if the fundamentals are sound there is no reason to sell a position that has had a good run up, however, I might look at that as an opportunity to take advantage of the capital gain and use it to bolster positions in my other holdings that might be of more value - i.e. those that for whatever reason are lagging behind a bit.

    Plus, wouldn't taking the gains and putting them into better value holdings help to balance out the dollar value of each position? That might be just me, but I like each of my stocks to be similarly weighted....

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  3. Excellent article to keep us thinking about the big picture. One questions: would not the logical conclusion to this be to always reinvest dividends (and not use those funds to "chase yield" in other investments). Love to hear anyone's thoughts on this.

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  4. Hi just wondering if it would make sense to switch from a lower yielding stock that you like (and own) to a higher yielding stock you like and own? For example from your post, if GWW is yielding <2%, why not switch over to JNJ which is also a "quality" stock?

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  5. What if the companies dividend growth rate declines considerably? I mean technically they are continuing to pay and increase but by so low amount. A company like (ED) currently has a growth rate of > 1%.

    Would that be a consideration to sell?

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  6. I would prefer to evaluate my options based on the ability to earn a higher $ income, because that is my objective and not about trying to get a higher % yield-on-cost.

    I should then be capitalizing my paper gains and redeploy the principal + capital gains to earn a higher $ return. The new % yield-on-cost might be low but on a larger capital base and if the absolute $ income is higher, then I am better of than before. At the same risk levels.

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