Deciding Whether to Dump a Dividend Stock? It's Tricky

In 2020 Real Money contributor, Tim Collins penned a piece titled, Buying a Stock is Easy - Selling It is the Hard Part and I tend to agree with that. As Collins points out, traders usually fall into one of two camps -- those who sell too early, leaving profits on the table, and those who sell too late, which minimizes potential gains. There are several reasons why we don't ring the register or trim back a position that is working when it's the right time. Sometimes that right time only appears in the rear view mirror when revisiting the position from start to finish as part of our life cycle investment strategy. And no, not everyone does that. Selling dividend-paying stocks, be they the ones issued by companies with a rising dividend policy or those that have enviable dividend yields, are equally as tricky, but there some helpful rules of thumb one can use to zero in on when it may be time to lighten up your position size. Watching the Dividend Yield Putting aside the fundamentals of each dividend payer, which are important because they drive revenue, earnings, and cash flow, the kind of financial metrics that enable a company to continue paying its current dividend or increase it, we tend to focus on the relationship between the dividend and the company's share price, usually in the form of its dividend yield. We find the dividend yield by dividing the annualized dividend by the current share price. For example, shares of Procter & Gamble are currently trading near $135, and their current quarterly dividend of $0.8698 when annualized sport a dividend yield of roughly 2.6%. One of the things I do when assessing upside with a dividend payer as well as determine potential downside is to look at the historical peaks and troughs of a company's dividend yield. In the case of PG shares, over the 2015 to 2020 period the average peak dividend yield was 2.7% on a range of 2.2% in 2020 to 3.0% in 2016, 2017, and 2018. The corresponding trough dividend yield averaged 3.4% and spanned a high of 4.0% in 2018 and a low of 2.8% in 2020. That 2.7% and 3.4% forms what I tend to consider the bumper guards, but we have to remember that the 2.7% shows where PG shares peaked while the 3.4% shows where they bottomed out. Again, the dividend yield is the annualized dividend divided by the share price. If the dividend yield is far below above the average peak dividend yield of 2.7%, it's time to at least consider trimming the position back some, and as it approached the absolute peak of the last few years, the 2.2% dividend yield I mentioned above, then I would be ringing the register for sure. Conversely, when the shares move above the trough dividend yield of 3.4%, it's time to start buying them back as with hindsight being 20/20 when they bottomed out at with a 2.8% dividend yield in 2020 it was time to buy hand over fist. The Dividend Is Cut Compared to the above example, a very clear sign that a dividend stock is likely to top out or has topped out is when the underlying company cuts its dividend or cancels it all together. Given the expectations by investors that dividend payments will be in perpetuity, announcements such as those are shocks to the system and indicate larger problems afoot a company. For the most part, when a company reduces or eliminates its dividend, it's time to say adios to the shares. If it's a cut, I'll put the shares on my watch list to see where they settle out relative to historical dividend yield bands like the ones above, but I also want to understand the why behind the dividend policy change before jumping back in. For example, Cato Corp. recently reinstated its quarterly dividend that was cut during the pandemic but chopped it by roughly 67% to $0.11 per share compared to the pre-pandemic level of $0.33 per share per quarter. Cato announced that move on May 20, and it's no surprise the shares have traded sideways in the ensuing days. Deteriorating Fundamentals When it comes to assessing a company's ability to increase or even maintain its current dividend, we have to understand what is going on with the company's core business. By that, I mean the business or business segments that are the lifeblood of its sales, earnings, and cash flow. If the fundamentals are positive, then there is a low risk of the dividend being cut. By comparison, if the fundamentals are challenged or deteriorating, like we tend to see with cyclically sensitive stocks late in the economic cycle, it can be a sign that either near-term dividend increases are unlikely or that the current dividend could be at risk. We saw this in 2020 when the pandemic and shelter-in-place orders collapsed energy demand to the point that oil prices flash negative for a brief time. That never-before-seen move led BP to cut its dividend for the first time in a decade. That announcement came on Aug. 4, 2020, and we can see the reaction in the shares in the below chart. One sign to watch for are credit downgrades by the likes of Moody's and other rating agencies, and these often precede a cut in a company's formal credit rating. When a company is slapped with a credit rating cut it means it will face higher borrowing costs, and companies will sometimes slash their dividend to preserve cash flow as well as head off any credit rating downgrades. Another sign to watch for is a suspended stock buyback as it signals the company may not have sufficient capital to support the buyback program.

Deciding Whether to Dump a Dividend Stock? It's Tricky

Here are some helpful rules of thumb to zero in on when it may be time to lighten up your position size.

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