Earlier this month, Walt Disney Co (NYSE:DIS) suspended dividendsfor the first half of 2020. The company had just become a dividend achieverand had a ten year history of annual dividend increases under its belt. I viewed it as a great brand, with a strong moatand as a buy and hold forever type of a company.
Avoiding Big Mistakes And Managing Risk
However, I also have a strategythat helps me avoid big mistakes and manage risk. In order to avoid falling in love with a company whose best days may be behind it, I sell after a dividend cutor a suspension. I buy a stockwith the intent of seeing it prosper, earning more income, growing to be more valuable and sharing a higher dividend with me over time. Only companies that have stood the test of time manage to even establish a lengthy track record of annual dividend increases through the ups and downs of several economic cycles. When management teams with a track record of dividend increases cut dividends, this tells me that something is different and I admit that I was wrong. I can always go back and initiate a position if a dividend is initiated and increased later.
After selling the stock, I realized that I am going to miss out on an annual income of $1.76 for each share that I owned.
All is not lost however. Just because a stock I own stopped paying dividends or reduced them, that doesn't mean I am not going to earn dividend income from that investment. I can always sell ( which I do after a dividend cut or a dividend suspension).
In my case, I managed to get a decent amount of money for my Disney stock, after I sold it.
I like to keep my money invested, because I believe that time in the market beats timing the market. I looked around and wanted to find a company that is in a similar part of the economy, in order to maintain sector allocations. I was able to redeploy the funds into Comcast. I informed the subscribers to my newsletter about this switch. I also added a sprinkle of Verizon and AT&T to juice things up a little.
For every share of Disney that I sold, I bought 2 shares of Comcast and 1/3 share of AT&T and 1/3 share of Verizon.
Disney's Dividend Cut
Let's do a few calculations to illustrate the point I am making.
Imagine that I owned 90 shares of Disney before the dividend cut.
By selling my shares of Disney, I lost annual future dividend income of $1.76/share for a total of $158.40. Well, I lost that future dividend income, because Disney suspended dividends. But in reality, I was expecting that much in annual dividend income from my Disney position, before the suspension.
By buying shares in Comcast, I added $0.92/share to my annual dividend income. 180 shares of Comcast generate a dividend income of $165.60/year.
Verizon pays $2.46/share in annual dividend income, while AT&T pays $2.08/share. Owning 30 shares of Verizon and 30 shares of AT&T results in an annual dividend income of $136.20/year.
If you add $165.60/year to $136.20/year you end up with $301.80/year.
In essence, I doubled my dividend income by selling Disney.
However, I do not like it when I grow my dividend income by selling a lower yielding stock, and replacing it with a higher yielding ones.
First, the risk is that the companies I bought end up not growing their dividend income, or even cutting it. Disney may turn out to have had a temporary issue, and comes roaring back. Or it turns out Disney ends up becoming the next Netflix. If I sold one stock to buy another, I may increase my income, but my total returns could be lower than simply staying put.
Second, the issue is that no two companies are the same. Therefore, getting into the habit of selling one company to buy another may turn the portfolio into a riskier and more concentrated one. We do not want to affect the risk profile of the portfolio, nor do we want to potentially end up overweighting or underweighting sectors ( if this were to happen). Speaking of risk and risk profile, we should not forget that there are largely 3 types of dividend growth stocks. One is low yield/high growth, those in the sweet spot of yield/growth and those with a higher yield and lower growth. We do not want to overweight one of these three types, because the portfolio profile and future growth will be affected. We want a nice balance, as each of those comes with its own sets of risks and opportunities.
Third, this strategy may teach investors that it is ok to just sell their lowest yielding stocks, in order to reach their dividend income goals faster. As we discussed in the paragraph above, this can affect your risk profile. Replacing lower yielding stocks to buy higher yielding ones could be a justification to chase yield. You may end up with a lot of higher yielding companies, which may be concentrated in a few sectors. Or they may be from different sectors, but have exposure to the same type of risks such as interest rates or regulation. These higher yielding companies may also have lower growth, which may result in inability to maintain purchasing power of your income in retirement. The higher yielding companies may have higher payout ratios, which may stifle growth in earnings and may expose those companies to a higher risk of a dividend cut during the next recession.
Replacing Dividend Stocks
Basically, replacing dividend stocks can be a mistake if done without a good reason. And it can turn otherwise wise long-term investors into antsy activetraders. I usually agree and stay put through any issues, for as long as the dividend is at least maintained. If a dividend is cut or eliminated however, I admit that I have been incorrect, and sell. After all, when I buy a stock, I expect it to keep growing earnings and dividends. If it stops growing those dividends and cuts them, then my initial expectations were wrong. If I am proven to be wrong, I see no reason to sit tight and hope for something that may or may not materialize. So I sell.
In my investing, I prefer to generate growth in dividend income organically. This occurs when a company earns more money over time, and decides to increase dividends from this source. This is a more sustainable strategy for future dividend increases. It is also preferable, because once you retire and stop contributing to your portfolio, you will need dividend income to grow above the rate of inflation. This is why organic dividend growth is so important.
The next preference goes to dividend reinvestment, which is the process where we deploy dividends received back into the portfolio. This step helps turbocharge dividend income and compound net worth in the accumulation process.