Wednesday, June 3, 2009

Replacing dividend stocks sold

Dividend investors should not rely too much on the dividend income from a single stock or a single sector. In an ideal situation, in a portfolio consisting of 40 stocks, each security would have an equal weighting. In other words one shouldn’t have more than 2.5% in a single security at the end of his or her target period.

In real life however things are usually far from ideal. What could happen is that some dividend stocks would outperform the others and thus their weightings could be disproportionately large. In order to maintain the equal weights, investors have several choices besides selling the best performers and placing the proceeds in the underdogs.
One of them includes reinvesting the dividends from the stocks with the highest weights into the stocks with the lowest weights.

Another option includes adding extra funds to the stocks which have a below average weighting in your portfolio, as part of your process of regular contributions toward your portfolio.
An important thing to add is that one should not consider adding to a position, which no longer fits two or more points from your entry criteria. My entry criteria consists of several bullet points including:

1) A stock which has increased annual dividends for at least the past ten consecutive years (preferably for at least 25 years)
2) A price/earnings ratio of under 20
3) A dividend payout ratio of less than 50%. In certain cases such as Master Limited Partnerships, Utilities or Real Estate Investment Trusts, which distribute the majority of their earnings to stockholders, compare the current payout ratio to the historical one.
4) A dividend yield, which at least matches the dividend yield on the S&P 500. This criterion used to be a 2% initial yield for the majority of 2008, until yields on the S&P 500 rose to the highest levels since the early 1990’s. Currently I prefer to invest in stocks with a current dividend yield of at least 3%.

For example, if you have a position in M&T Bank (MTB), you would be receiving a quarterly dividend of $0.70/share. M&T Bank last raised its dividends in July 2007. Unless the bank raises its dividends by the end of 2009, it would lose its dividend aristocrat status.
Because of the unchanged dividend, I stopped re-investing dividends in the stock by the end of 2008. I also stopped adding to this position as well. The dividend payout is slightly above 50%, while the P/E and the yield are pretty attractive at 12.7 times earnings and 6%. Another thing that concerns me about M&T Bank is that it took $600 million in TARP money back in December 2008. My experience with other banks, which received TARP money, such as Bank of America (BAC), US Bancorp (USB), Wells Fargo (WFC) and BB&T (BBT), is that TARP receivers are very likely to cut their dividends.

Since I have started reinvesting my MTB dividends into other companies I own, my allocation in the stock has dropped to about 1.7% of my total portfolio value. This position contributes about 2.20% of my total annual dividend income. My yield on cost is 4%. If the dividend were cut while the stock was trading at $46 however, I would sell the stock.

The question now is what should I do with the money I received from the sale. My dividend income would be lowered, and I would now have $46 to invest, which is lower than my average cost of $69/share. In order to maintain my dividend income of $2.80/share, I would have to purchase $46 worth of shares in a dividend stock, which currently yields at least 6%. In the current market it is possible to find a solid dividend stock, which yields at least 6%. One example that comes to mind is Consolidated Edison (ED). Another is Kinder Morgan Partners (KMP). It is important to try and keep sector weights as well however.

On the other hand I could simply accept that my dividend income for this portion of my portfolio would be lower and simply invest in a promising candidate such as Johnson & Johnson (JNJ) or Abbott (ABT). It is more important to have a diversified stream of dividend income, rather than chase the highest yielding stocks when replacing dividend stocks sold in an effort to maintain your previous levels of dividend income. Check my example with General Electric (GE) for more clarification.

Back in February 2009, General Electric (GE), which was one of my favorites until the end of 2008 announced its intention to cut its quarterly dividends to the lowest levels since 1997. I immediately sold my position at a loss for $8.63/share. My cost basis was $28.97/share. My dividend income was $1.24/share, while my yield on cost was 4.30 %. The new dividend would have been $0.40/share, which makes up for a yield on cost of only 1.40%, much worse than rates on Certificates of Deposit. Even though I had stopped contributing to my GE position by the beginning of the fourth quarter 2008,GE made up about 1.00% of my portfolio value. This position also contributed about 3% of my total annual dividend income. Thus, in order for me to generate $1.24 in dividend income for every GE share that I sold, I would need to purchase a stock yielding 14.40%. In the current market, most stocks that pay such a high current dividend are very likely to cut their distributions. Thus, maintaining the dividend income just for this portion of my dividend portfolio was not worth the risk of chasing the highest yielding stocks. Instead I purchased shares in Abbott Labs (ABT), which generate almost the same income that I would have received had I not sold my GE shares. While in retrospect my sale of GE stock seems foolish as the shares have risen almost 50% since then, I do not see the same potential for dividend growth that I see for Abbott (ABT). With Abbott (ABT) I see the potential for stable dividend growth, fueled by its strong new product pipeline and the potential for initiatives in the medical device and pharmaceuticals fields. In retrospect I could have added to my position in Kinder Morgan instead, but this could have lead to me being overweight the largest master limited partnership in the US, which is something I try to avoid.

My overall dividend income is up almost 3% year to date, after several reliable companies such as Johnson & Johnson (JNJ), Procter and Gamble (PG) and Coca Cola (KO) continued their long history of sharing prosperity with shareholders through regular annual dividend increases.

Dividend investors who are trying to replace the lost dividend income from stocks, which cut or eliminated their dividends, should realize that it is important to diversify the number of holdings that generate income for them. While a dividend cut or elimination from a stock that generated 3% of your portfolio income hurts, one should keep an eye on the big picture and not repeat their mistakes. It is the diversified income stream that counts and not replacing dividend stocks sold with the highest yielding stocks matter, which would certainly increase risk. At the end of the day, the dividend cutter has already compromised your dividend income. Taking on a higher risk only leads to a vicious circle of not focusing on dividend growth potential, but on chasing the highest yielders, which is a game of wealth destruction.

Relevant Articles:

- Abbott Labs (ABT) Dividend Stock Analysis
- Dividend Cuts - the worst nightmare for dividend investors
- When to sell my dividend stocks?
- More Dividend Stocks to Avoid

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