Wednesday, September 6, 2023

Should I sell or should I hold

There comes a time in the life of every investor, where one of their holdings experiences troubles of some sort. It doesn’t matter how much research you did upfront, you will have those.

I’ve had those too. 

Typically a company would have missed earnings, and the share price would go down or stay flat for extended period of time. Some shorter-term investors would panic, and start abandoning the ship. The sentiment turns sour, and more people start abandoning the company. Just mentioning the name makes people uncomfortable, let alone have them admit they have ever owned it.

I’ve had those too.  In fact, I probably have a few of them right now.

I have learned that I do not know in advance if a company’s troubles are temporary or the beginning of the end. Few can tell really.

I do know however that I should hold tight for as long as possible, for as long as the reason I bought still holds on.

I buy companies with a long streak of annual dividend increases. When I buy a company, I believe it to be a quality company selling at what I believe to be fair valuations. For as long as that company can at least maintain dividends, I would hold on to it. I would likely not add to it if fundamentals do not meet my entry criteria, but I would hold on to it.

As someone who has spent a lot of time reviewing dividend histories for a lot of companies (dead or alive), I can tell you that dividend growth does change from year to year and from cycle to cycle for different companies. It is rare to see a company grow at the same rate of dividend growth all the time. In reality, dividend growth goes up, then goes down, and may even turn flat as companies experience short-term turbulences. The best businesses adapt, and thrive. They take punches, consolidate, but then get back on their feet. They only tend to cut dividends when something is irreparably damaged. This typically tells you that the business environment or the product or the company no longer rides the same tailwind that produced the historical record of success. This means this change has caused this business to be outside my circle of competence in defiance of my original expectations, so it’s time for me to move on to some other long-term trend that can build wealth. 

I would sell in an instant however one second after the company cuts or suspends its dividend.

I would be very patient in holding through the ups and downs, and give the company as much time as it needs to turn the ship around. Even if it takes 5 or 10 years. I invest for the next 20 – 30  years or longer, so I can afford to hold for as long as they don’t cut the dividend. Many would have opinions, and have fear or greed, but I would be able to hold on and sit tight, for as long as I am getting paid to hold and that amount is not cut. If that dividend is cut however, then my original reason for owning the stock (enjoying a stable and growing dividend income) is not longer valid. That’s a fact that causes me to sell.

I follow a fact based approach to investing. I do not care about hopes and dreams and opinions, but facts. A dividend cut is a fact, so I sell. If the dividend is unchanged, then that’s a fact that causes me to hold. 

Management teams in the US are reluctant to cut dividends, because they view it as a failure. They are right, it is a failure. 

I do not want to sell a stock willy-nilly, just because there is some pressure. There is a trade-off of course. The issues companies face could either be temporary, in which case selling would have been a mistake. OR The issues companies face could be permanent, in which case selling is the best decision. But if you have to choose between worrying that you sold a value trap at $10 or $5, it doesn’t really matter in my opinion. It matters to keep amount at risk limited, and try to own companies that may grow EPS/DPS and intrinsic value.

If that pressure turns out to be right, and I sold “early”, I will have retained a higher amount of money to redeploy elsewhere. At least in theory. Otherwise, the theory says, by the time the dividend is cut and I sell, it would be too late. (They are probably right, but I also know that I won’t be right 100% of the time and I do not need to predict every twist and turn in a company share price. I buy companies with the expectation that they do well over time. If I am wrong, I cut my losses and get out when dividends are cut. I also keep amount invested per stock limited, so as to protect my capital when bad things happen to (good people -me ))

If that pressure turns out to be wrong however, and I sold “early”, I would have wasted a high amount of money by selling low and missing out on all upside. At least in theory. The theory says that if I try to predict a dividend cut that never comes (meaning I am wrong), I would be selling low and it would be too early. It could be even worse if I end up missing out on all the future prosperity and also ended up replacing a perfectly good company with something that turns out to be a value trap on its own. Compounding mistakes is never fun.

I know that this is getting to be a little bit of a rambling post, so let me provide some examples from my own experience.

Back in 2014 – 2017 we had McDonald’s (MCD) share price go nowhere for a few years. Earnings had started to stagnate, and people started to create all sorts of narratives about things. A lot of folks sold their stock. The company then simply managed to try and right the ship, and has managed to double earnings per share in the past 6 years. The stock has rebounded and dividends per share are rising as well.

In this case, holding on seems like a good idea. I’d tell you however that a lot of folks disagreed with me and argued with me against me holding. Urging me to sell. The issue is if I sold, I would have likely bought another company that may have done worse than McDonald’s. So I would have had a double loss of missing out on McDonald’s prosperity and ending up with a value trap.

This is not the first time McDonald's investors had their patience tested out. Back in the early 2000s, the company had experienced some growing pains, it had overexpanded and level of service had been declining. We also had an increased attention to the fact its food is not very healthy (remember "Supersize Me"). That being said, for the investor who held on, they did well. Of course, if they hadn't turned the operations around, and had cut dividends, the picture would have been much different.

Perhaps it’s still early to tell, but I am also holding on to Cardinal Health (CAH), a position I initiated about 5 years ago. The investment had been dead money for quite some time, and has generated abysmal annualized dividend growth over that time period. However, the share price has almost doubled, so perhaps the market is foolishly or smartly predicting that things are about to turn around. Perhaps EPS growth and dividend growth would return? That being said, the company is on track to earn $6.67/share in 2023, versus $3.42/share in 2014 and $4.54 in 2019.

I experienced a few years of slow dividend growth with the types of oil majors such as Exxon-Mobil over the past decade, particularly since 2019. Remember when oil prices turned negative in 2020, amidst the glut around the time after Covid hit? Several companies like Shell or BP cut dividends. Share prices were down for every oil major, including Exxon Mobil and Chevron. If someone sold in anticipation of a dividend cut, they would have sold low. Oil prices ultimately recovered, and so did share prices. I do remember sentiment being terrible for the energy sector in 2020. One of risks of selling after a company has not done well, is that you let emotions such as fear drive the actions. As a group, investors tend to feel the worst and most likely to capitulate around the time of a major bottom. We want to avoid that. However, we also want to avoid hoping for a turnaround that never happens, tying up precious capital in the process. This is where having an objective signal can be helpful in knowing what to do. That signal for me is the dividend - if it is held, I will hold on to the company. If it is cut, I will sell and re-evaluate. If it is increased again in the future, I would consider initiating a position again.

Two companies I am in the red today include 3M (MMM) and Walgreen’s (WBA). I’ve held those for over 10 – 15 years. When I bought them, they were considered to be quality dividend aristocrats, and they had managed to grow earnings and dividends at a good pace. In fact, they have increased dividends at a decent pace over the past 10 – 15 years.

In the case of Walgreen’s, the company had strong earnings growth and dividend growth prospects around 2010 – 2011 - 2012. Dividends have doubled over the past decade. Earnings per share also almost doubled from $2.69 in 2013 to $5.02 in 2022. It’s expected to earn $4/share in 2023, and pay $1.92/share in dividends. The dividend seems adequately covered from earnings. Dividend growth has come to less than 1% in 2022 and the company has skipped its dividend increase so far in 2023. I understand that things are looking hard, and there are a lot of competitive pressures. I will stick to the stock for the time being, for as long as the dividend is not cut. I viewed Walgreen’s as a growth stock about 10 – 15 years ago. It’s just a good reminder that you should not chase growth, just the same way as you should not chase yield either. Either way, I am sticking to this stock for as long as they don’t cut the dividend. I am not adding to it however. 

In the case of 3M, the company has managed to grow earnings per share at a decent clip between 2013 and 2022 from $6.83 to $10.21. It’s expected to earn $8.87/share in 2023. It pays a $6/share annualized dividend, so the distribution has a high payout ratio of around 67%. It’s manageable, for as long as earnings do not dip further. Any lack of future earnings growth would mean lack of future dividend growth as well. There are some lawsuits around, which are taking managements focus away from running the business in my opinion. Once these are behind us (or if they are behind us), they have the chance to regroup and hopefully get the business back on its feet. Either way, I am sticking to this stock for as long as they don’t cut the dividend. I am not adding to it however.

The annualized dividend growth for 3M has definitely been very slow over the past 4 - 5 years. The company has increased the quarterly dividends by 1 penny/share since 2019. This is not the first time that 3M's annualized dividend growth slowed down. However, that was around the time of the Global Financial crisis, when expectations were low and the issues surrounding that dividend increase were affecting more companies and the whole economy. It's much harder to take the pain when everyone else is doing well.

Another fun company I hold on to is Altria (MO). Back in 2017, the stock was overvalued, selling for roughly 25 - 30 times free cash flows per share. Free Cash Flow per share went from $2.12 in 2013 to $2.45 in 2017 to $5.02 in 2022. Yet, today the stock sells for 8 times Free Cash Flow/share. The stock price is down from a high of $70 - 75/share in 2017 to about $40 - $45/share in 2023. While management did burn billions of dollars on some terrible acquisitions (JUUL and Cannabis), the core business seems to be printing money for the time being.

Of course, tobacco has been a challenging business to hold, if you go by news headlines at least. Back in the late 1990s, tobacco companies almost went under due to heavy litigation. After the Tobacco Master Settlement Agreement, tobacco companies bounced back and kept printing cash to shareholders. There were some challenging times in the late 1990s, but shareholders who persisted despite the negative news headlines did well. There were no dividend cuts from the likes of Altria (then Phillip Morris). Phillip Morris did fail to raise quarterly dividends in 1997, though it did raise them in the third quarter of 1998. However, due to the timing of the increases, annual dividends kept increasing in 1996, 1997 and 1998, thus preserving its status of a dividend aristocrat. Again, nobody knew what would happen with tobacco in 1996 or 1997. But someone who held on for as long as the dividend is not cut would have done fine. If they had cut dividends however, mostly due to unfavorable litigation, that would have likely marked the end of the sector as an investable opportunity. However, someone who sold in fear of failure in 1997, would have likely regretted their behavior, as the company has delivered amazing total returns and dividend growth over the past 25 years.

I summary, when I invest, I try to buy shares in a quality business, at an attractive valuation. That business has a track record of annual dividend increases, which I expect to continue. I will continue holding on to that business, for as long as it does not cut or suspend dividends. 

Ultimately, it is hard to say in advance whether a business is experiencing temporary struggles or whether this business is experiencing an existential crisis all the way down to zero. This is why I keep holding on through the ups and downs, until the dividend is cut.

One of risks of selling after a company has not done well, is that you let emotions such as fear drive the actions. As a group, investors tend to feel the worst and most likely to capitulate around the time of a major bottom. We want to avoid that. However, we also want to avoid hoping for a turnaround that never happens, tying up precious capital in the process.

I also limit the amount of money I will allocate to that business as well, which limits the amount at risk for this particular position. I have a diversified portfolio, which I build over time as well, which serves as protection from the proverbial bad apple. 

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