Wednesday, May 15, 2013

Why would I not sell dividend stocks even after a 1000% gain?

In a previous article I wrote on when to sell dividend stocks, many investors were absolutely furious that I would not even think about selling after a stock I own goes up 1000% in value. The reality is that this would depend on the circumstances, but since I am a long-term investor, I expect that at least some of the stocks I purchase today would become tenbaggers over the next 30 years or so.

In order to add shares in companies to my portfolio, I go through a quantitative screening process, followed by a qualitative review of the business. The qualitative portion is the most subjective one, and is based on my experiences consulting companies, using products or discussing products with company’s clients etc. As a result, I try to enter companies which I believe would be there for at least 20 – 30 years, when their shares trade at fair prices. If they are undervalued, that makes investing in them much easier. For example, based on my prior experience I would much rather purchase an oil company like Chevron (CVX) or ConocoPhillips (COP), than an individual US oil and gas trust that will be worth zero in a few decades. I could probably write an article about that.

Dividend growth stocks follow a natural progression of slowly increasing earnings and dividends over time. They almost always look fairly valued, which is why the biggest benefit is earned by long-term holders. If I purchase a stock like Chevron today while the annual dividend is $4/share, the current yield is at 3.30%. Chances are that one decade from now, the yield would be close to 3% again. However, the dividend and the share price would have probably doubled along the way.  I say probably in regards to the dividend growth, because things never progress in a linear fashion of course. Using the inputs above however of dividends doubling every decade, and stock prices yielding somewhere close to 3%, it would not be unheard of if an investor in Chevron sits on an 800% – 1000% gain in 30 years. If there isn’t a tectonic shift that would take the world off of oil and gas, chances are that this growth is a very likely scenario that would continue for several more decades.

As a result of focusing on quality companies, there are few things that can make me sell. I view myself as a part owner of a business, and as a result the business fundamentals such as returns on equity, earnings per share and dividends per share are more important than share price fluctuations.

One of the things that would make me sell is a dividend cut. My expectation is that a company would generate higher dividends over time, and thus the inability to do so is usually the last signal of deteriorating financials I am willing to take that shows trouble. I do expect to get a high yield on cost over time, although this indicator is not something i use when evaluating buy or sell decisions. If everything goes well for my investment, I would expect it to generate more dividends over time, which would increase yield on cost, which is an indicator of an increase in dividend income. This indicator always seems to confuse and anger investors for whatever reason. I would not sell a stock simply because it becomes overvalued. For a typical dividend growth stock, if it traded up to 30 times earnings it would be more of a temporary noise, especially if this is backed by serious growth.

Dividend investing is not a black and white strategy however, and as such, a P/E of 30 might cause me to sell some stocks but might lead me to hold on to other stocks. The nuances of holding on to overvalued companies that keep performing will vary for each individual situation. Even if I were to sell a stock with a P/E of 30, then I would have to pay a capital gain tax that would eat into my capital and find a security that is attractively valued. If we happen to have the stock market trading at all-time-highs, and all other quality companies are overvalued, I would have essentially shot myself in the foot.

As an individual dividend investor, I have a limited amount of time that would allow me to identify and invest in approximately 50 – 80 great stocks during my lifetime. Of those, probably 15 – 18 would perform to be once in a lifetime investments. The rest would get acquired, lose focus or outright fail. As a result, my goal is to run with the winners for as long as possible and get rid of the losers as soon as possible.

The number one reason why individual investors fail is because they tend to book small profits. At the same time they keep their losers hoping for a turnaround. Instead, they should focus on identifying quality companies, and then let fundamentals improve and simply hold on to these great ideas. It is difficult to be a long term investor when you are bombarded with stock market information everywhere you go. However if you do not embrace a long-term approach to investing, and do not see shares as ownership in real businesses, chances are dividend growth investing is not for you.

There is a lot of work involved in timing the movements of stocks, and selling a company that might be overvalued today to purchase another company. I have found that there are only so many quality dividend stocks I am willing to consider looking at. Finding the right company trading at the right price narrows the list down even further. Then there are things such as avoiding concentration to specific sectors as well as avoiding concentration in particular individual positions as well. As a result, I buy and hold on to stocks that fundamentally perform well. I could sell the stock and buy another one, but I might increase the risk that I am buying something that could be of lesser quality, despite the high price. For example, I could sell Johnson & Johnson (JNJ) today and purchase NuSkin enterprises (NUS), which have a much lower P/E. However as I mentioned in my analysis of NuSkin, I find it to be of lesser quality than a Johnson & Johnson.

As a dividend investor, I do monitor the positions I have regularly. However, from a psychological perspective I have found that a daily monitoring of my portfolio for major events might increase my chances of doing something stupid such as trading too often. In reality, as a part-owner of a business, there are not many events that would happen every day, which would materially affect the business. Again, this is more of a nuanced approach as opposed to a black and white strategy. I do want to see improving fundamentals over time, as well as catalysts that would bring more income. For example, Coca-Cola (KO) is a brand whose products would likely continue to quench the thirst of consumers, who would only drink the specific products sold by the company. I would never for example drink Pepsi, although I know some individuals who would always drink Pepsi and hate Coke. There are hundreds of millions of consumers who will be entering the middle class in developing markets in Asia, Latin America or Eastern Europe. If people in India and China eventually consume as many servings of Coke per year as Americans do, Coca-Cola will have a bright future ahead.

Back 1988, Warren Buffett began accumulating shares in Coca-Cola (KO) for his holding company Berkshire Hathaway (BRK.B). Currently, Berkshire owns 400 million shares at a cost of $3.2475/share. Berkshire’s stake has increased its value over 11 times over the past 25 years. At the same time, the company has been more valuable, as it has managed to increase profits and dividends. The stock price was overvalued in 1998, seeling as high as $45/share, and having a P/E of 48 by year end and an yield of 0.80%. EPS for 1998 were 71 cents/share. Buffett did not sell his stake, and earnings per share rose to $1.97/share by 2012. The issue was that Coca-Cola was consistently trading above 20 times earnings between 1992 -1998. Since 1995, Coca-Cola traded at a P/E of over 30 times earnings. The stock didn't become attractively valued until 2006. In hindsight, it’s easy to tell when to buy and sell. In reality, it ain’t so. Berkshire Hathaway currently is sitting on more than a 1000% gain in Coca-Cola. Chances are that it would keep on holding the stock, and since Coca-Cola regularly repurchases shares, Berkshire's stake in the company will keep increasing over time.

Buffett did sell another one of his holdings, McDonald’s (MCD) in 1999, when the stock traded around $35 - $40/share. The stock fell as low as $12/share in 2003, before reaching $100 by 2011. The dividend increased each year during the period, although McDonald’s did have some operational issues in 2002 – 2003. In effect, Buffett missed out on this great investment idea.

Full Disclosure: Long CVX, COP, MCD, KO, JNJ, PEP,

Relevant Articles:

The right time to sell dividend stocks
Twenty Dividend Stocks I Recently Purchased for my IRA Rollover
Dividend Growth Stocks – The best kept secret on Wall Street
Why Dividend Growth Stocks Rock?
Warren Buffett – A Closet Dividend Investor
- Carnival of Personal Finance
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