Monday, June 6, 2011

Natural Selection in Dividend Portfolios

Investors should purchase stocks with the intention to hold on to them forever. They should spend time analyzing the stocks to purchase, fine tuning their strategies and diversifying their portfolios properly. However they should realize that things and conditions change. Sometimes the best decision investors could do is sell their stocks when changes occur. As a result, even a portfolio of carefully selected wide moat companies could have big turnover over a time period of several decades. Nevertheless, it is important to try and select only the best dividend stocks after a rigorous screening on such lists as the dividend achievers or the dividend champions. Investors do have to remain nimble and on top of things, as any changes could lead to portfolio turnover over time.

The changes that could occur include buyouts, dividend cuts, spin offs and changes in the business environment. I highlighted several conditions which would make me to sell my dividend stocks in this article.

Many prominent dividend stocks could be attractive buyout targets for larger rivals or by companies which are looking to diversify into a new line of business. Shareholders usually receive a big premium which ensures that almost everyone makes a profit in the process. This doesn’t take into consideration the fact that a growing company might deliver much higher total returns if it stayed independent.

Recent examples of buyout include the acquisition of dividend aristocrats Anheuser-Busch in 2008 by Inbev (BUD). At the time the company which controlled almost half of the US beer market had a dividend record of 32 years of consecutive dividend increases.

Other examples of successful dividend growth stocks bought our include the Quaker Oats acquisitions by PepsiCo (PEP) in 2001 as well as Berkshire Hathaway’s (BRK.B) acquisition of GEICO in 1996. Investors who received stock in the acquirer had to evaluate whether they should keep it or sell it. Investors who received cash had to find other attractively valued replacements for their dividend portfolio.

The opposite of buyouts is spin offs, which is the creation of an independent company through the sale or distribution of new shares of an existing business/division of a parent company. Back in 2007 Altria Group (MO) spun off Kraft Foods (KFT) and distributed shares in the food company to its shareholders. In 2008 Altria also spun-off Philip Morris International (PM). This led to a decrease in the net dividend from 86 cents/share in 2007 to 29 cents/share in 2008. The company was a member of the dividend aristocrats index and boasted a long record of consistent dividend increases. After the spinoff however, it was removed from the index. Investors who closely followed the elite dividend index disposed of the stock. Others which used a more discretionary investing strategy had to evaluate the business of three companies – Altria Group (MO), Philip Morris International (PM) and Kraft Foods (KFT). All of the companies have been able to increase dividends since the spinoff.

Another corporate event which has been a decisive sell signal for many dividend investors is when companies cut or suspend dividend payments. Companies typically cut dividends as a last resort of action, which is why a dividend cut truly shows how dire the business conditions for the company really are. Selling right after a dividend cut has been a smart move. Overall investors who sold immediately after the dividend cut in 2007 and 2008 avoided major blowups such as Citigroup (C) or Washington Mutual (WM). This is typically when I sell my dividend stocks as well and then reinvest the proceeds in stocks which are attractively valued and have strong dividend growth potential. In my experience as a dividend investor, companies that cut dividends either have their stock prices decimated to zero or stage a huge recovery. Investors who purchase dividend cutters are playing against all odds, since a 100% gain followed by a 90% loss would not lead to sustainable wealth accumulation over time.

Full Disclosure: Long KFT, MO, PEP and PM

Relevant Articles:

- Six Dividend Stocks to Hold Forever
- Dividend growth stocks are attractive buyout targets
- Philip Morris International versus Altria
- Replacing dividend stocks sold


  1. What are readers' general thoughts on what I call "Yield Augmentation," selling a stock that has appreciated so that its yield is now pulling down the portfolio average yield and replacing it with a higher yielder. For example, if you start out with 10 stocks each with a 3% yield, then one of them appreciates 50% so that it yields only 2% now, you could replace it with another 3% yielder. This is one other contributor to turnover in my portfolio beyond the factors discussed in the article.

    Do please share your thoughts.

  2. How could you hold something forever?

    Quick examples:
    - Only 202 of the 500 biggest companies in the United States in 1980 were still in existence 20 years later.

    - On December 29, 1989, Tokyo's Nikkei stock average reached its all-time peak of 38,915.87. Twenty years later, the Nikkei has never again reached that level — and, in 2009, reached a new low of 7,054.98.

  3. I was looking at KFT as well but noticed that they did not raise dividends in 2010 (1.16 for 2009 & 2010).

    Am I missing a spin-off, split or other that may be impacting this?

  4. @Financial Independence asks how you could hold something forever?

    "Only 202 of the 500 biggest companies in the United States in 1980 were still in existence 20 years later."

    Well if you selected out of the 202 remaining companies, you could probably then "hold forever" .....not a difficult task for dividend value investors.

  5. First anon -

    I struggle with that quite a bit... I was fortunate to buy CAT back when it was ~40 and had a solid yield, where as now not so much.

    In general as long as they are continuing to raise dividends I try to focus on yield on costs (which would still be at your ~3%)

    If you do focus on yield on cost, selling a big gainer will only hurt because you will pay some form of capital gains and therefor are reducing your YoC by at least 15% (plus additional commissions etc).

    I would definitely enjoy hearing others views

  6. To the commenter who owns CAT for a big gain:

    I think that in order to look at the decision to sell CAT, you should take the scenario one step further and consider what you would replace it with. I'm guessing that when you bought it CAT had about a 4.2% yield, so if you bought $10,000 worth you would get $420 in dividends. In round numbers, your stock is now worth $25,000 and you get $441 in annual dividends.

    If you sell now, pay 20% in taxes on the gains, use the net proceeds of $22,000 to buy another 4% yielder you will earn $880 in annual dividends, about double where you are now. This is what I called "Yield Augmentation" in my post at 5:16 AM up above. If income is your top priority, it might be worth a try.

  7. 612am anon:

    I completely agree, and selling my CAT for additional div income is definitely a goal. Exit criteria is something that I always struggle with and as a whole I am usually hesitant to sell in a situation like this because I try to avoid chasing yield.

    Assuming everything is properly screened and it is an extreme case where a large run-up has majorly depleted your yield I would agree with you.

    Overall though, I do try to focus both at yield and cost and my yield at a portfolio level. If you did have 30-ish stocks the impact will still be noticeable bot closer to 30bps not 2-3%.

    As always would enjoy hearing any thoughts

  8. Also, anyone have any comment on the KFT annual dividend raises? Did I read it wrong / am I missing something?



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