When to Sell a Dividend Stock

Josh Peters: Hello, this is Josh Peters, editor of Morningstar DividendInvestor. We've all heard that the idea with stocks is to buy low and sell high, right?

Well, dividend investors know that this isn't the only way to make money, that these dividend checks, these portions of a cash earnings of a company that you're receiving directly from a share of common stock are also a good way to compound your total return, produce a good amount of income, and reduce your risk over time.

Of course, the buying and the selling is still a natural part of investing in any stock regardless of what its dividend might be. You might have a pretty good idea of what you're looking for when you're going to buy a stock for its dividend, but what are the kinds of questions you might want to ask if it looks like it might be time to sell?

With the market obviously a lot closer to being high than low compared to a year ago, this sounds like as a good a time as any to consider what might make you want to sell a dividend-paying stock.

Now obviously if you think that something is going wrong with the dividend by a particular company, you're going to want to consider selling that stock.

If you could have forecasted all of the companies that were going to reduce their dividends through the latest recession and sold them out long before those dividends were actually cut, you probably could have saved yourself a lot of losses. I certainly wish somebody had told me how bad things were going to get.

But there are other reasons that you might want to consider selling a dividend-payer that don't necessarily have to do with crisis management, just because an existing situation is going bad. This gets into the realm, sometimes fuzzy, of valuation.

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I'd like to use a specific example. One of my favorite companies for a very long time is a company called Realty Income. Its ticker symbol is O on the New York Stock Exchange. This company actually goes under the slogan "The monthly dividend company," because that's what the company does. It is structured to own a portfolio of real estate with very little leverage compared to its peers, collect the rents from these properties and use them to pay dividends on, you guessed it, a monthly basis.

Usually over the last couple of years, you've been able to buy this stock with a 6% or 7% or maybe even 8% yield. Very, very competitive with what you can get from fixed-income offerings. The trouble is right now--if we want to call it trouble--is that the stock, like many other stocks, has gone up. Realty Income right now yields less than 6% percent. Its share price is actually above our fair value estimate of $29.

Now does this mean that I want to consider selling Reality Income? Well, I think a good place to start is with the fundamentals. Is there anything wrong with the company? As far as we can see, there isn't. The company has managed its portfolio very, very deftly through this downturn.

The decisions they put in place long before the downturn started helped save shareholders from a lot of losses, potential dividend cuts that many of the company's peers have had to take. There isn't a problem with leverage. The company itself looks very sound.

So then it moves on really to a question of price and relative opportunity, which is if I sell Realty Income what could I do with the money that perhaps would yield me a higher total return? This question becomes a lot more complicated because when one stock in a particular industry becomes expensive, chances are pretty good that a lot of its peers have become expensive, maybe the whole market has gotten to be a little bit on the pricey side.

So then the question moves on further to is the situation so overpriced that you'd rather own cash? On the case on Realty Income, I think I can still earn a decent total return, not the plus-sized, double-digit total return I think I could have earned if I was buying the stock in the low $20s for example.

But even at $30, I think I can go on to earn perhaps a 10% annual total return on average on my money. That's still pretty good even if there's not a big margin of safety. It's a good enough reason to call the stock a hold as opposed to a buy.

The only point in which I would really want to let a company like this go is if it became so overpriced that I was not likely to earn a positive total return, even over a period of many years and even taking dividends into account. This type of situation doesn't happen very often with high-yield stocks. But you can put cash into your opportunity set, just like any other stock.

In the case of cash, right now it yields zero, but at least you'll get your money back. There are a lot worse things that can happen than zero.

Perhaps the final point that you want to consider about a stock that perhaps looks fully priced or even a little overpriced is what kind of quality does this business really offer me for the long run?

I discovered that high-quality companies, in my experience anyway, tend to surprise on the upside. They do better in the downturn than you would have expected. They also do better in the good times than you would have expected. While stocks whose main selling point is that they're cheap but the business is maybe average, maybe not even as good as average, tend to disappoint both in good times and bad.

In my case, Realty Income provides yet another example. At the end of 2007, I thought I had a fantastic opportunity to buy shares in what looked to me like a very cheap bank stock at the time, a company called Synovus Financial--symbol SNV--and in order to do that I didn't have any cash and I was actually willing to sell a few shares of Realty Income, which at the time looked a little bit expensive relative to our fair value estimate, much as it does now.

In that case, I was trading perhaps in terms of upside potential, or so I thought. But I was trading down big-time in quality. Once the recession really started to set in, Realty Income was well prepared, was able to sail right through without cutting its dividend, in fact continued to raise its dividend.

Synovus had many, many loans go bad in its portfolio and was forced to reduce its dividend several times and is now struggling just to stay afloat. Hopefully it will have enough capital to offset all the losses in its portfolio, but that remains to be seen. What I thought I was getting in terms of valuation, in terms of quantity of total return, I certainly wasn't getting in terms of quality.

So the kind of stocks that you might want to consider selling if they're just mildly overvalued would be the lower-quality names in your portfolio, perhaps the ones that did reduce their dividends through the downturn or ones that don't offer good dividend recovery or growth prospects going forward.

Take that as an opportunity to move up the quality spectrum a little bit or depending on the circumstances, maybe even hold some cash for a correction that might come along and make stocks cheaper.

So there you have it. Selling is not always a straightforward question. There are a lot of different things to think about. But I hope I've been able to give you a couple of good questions to ask before you think about letting go of a dividend paying stock, especially if it's one that has treated you very well over the last couple of years. Good companies are hard to come by and once you find them, very often, they're worth hanging on to.

With that, I'd like to thank you for watching. This has been Josh Peters, editor of Morningstar DividendInvestor.