When Do You Sell Good Dividend Paying Stocks?

Dividend Investing, Technical Analysis, The Fed

Which dividend stocks should you sell, and which should you keep? The stock market is setting records. Since the bank bailouts began in 2008, it’s no wonder. Interest rates dropped to historic lows, causing the stock market to soar.

We recently discussed the acronym, TINA (There Is No Alternative). Investors, particularly baby boomers and retirees have few options to invest safely and earn a decent yield.

Remember the term, “Widows and orphan stocks?” Those were solid companies that never missed a dividend. You put the stock certificates in a drawer and collected income for the rest of your life.

Today their stock prices are high, resulting in a low dividend yield for many of these solid companies. Investors needing more income, looked to other dividend opportunities to enhance their dividend yields.

Earlier this year I interviewed Tim Plaehn, a former Certified Financial Planner, F-16 fighter pilot and dividend expert with Investors Alley. His publication, “The Dividend Hunter” has demonstrated great success finding and building a solid portfolio of dividend paying stocks offering both yield and appreciation.

Tim recently sent out a recommendation to his subscribers, suggesting they sell and take profits on some specific stocks in their portfolio.

Many investors recognize they have a larger than comfortable allocation in dividend stocks. If there is a big market correction it could take years, and lots of dividends to make up for potential losses.

How do you decide what and when to sell?

I contacted Tim and asked if he would share some of his expertise with our readers.

DENNIS: Tim, thank you for taking your time to educate our readers on when to sell high-yield stocks, especially if they look to be doing well.

Recently Wolf Richter outlined the anticipated effect of the Federal Reserve not only raising rates, but also unwinding billions in bonds they currently hold:

“The Fed will reduce its balance sheet by up to $50 billion a month in Treasuries and mortgage-backed securities … $1.2 trillion in two years. QE was designed to bring yields down and inflate asset prices. Now the opposite is being planned, and markets are just blowing it off.

… No one knows how this will turn out. The Fed has never done a QE-unwind before. …The Treasury Borrowing Advisory Committee – pointed out some of those risks…

… For example, …corporate and government borrowing costs are likely to rise. At the riskier end, borrowing costs could rise significantly.”

Tim, as you pointed out in your article, interest rate sensitive Real Estate Investment Trusts (REITs) and other high dividend payers are vulnerable. Can you briefly explain what makes them vulnerable?

TIM: Thank you for inviting me. I was discussing a specific group of REITs, known as residential mortgage-backed securities (MBS). These companies own portfolios of residential mortgages which are highly leveraged to generate an interest rate spread between the MBS yields and short-term borrowing costs.

By leveraging their equity 6 to 8 times, these companies use the rate spread to turn sub 3% government backed MBS yields into double-digit REIT yields. In simple terms, rising short-term interest rates – the REIT’s borrowing costs-squeezes the spread and can decimate the net cash flow.

DENNIS: If corporate borrowing costs increase as Mr. Richter suggests, some companies may have trouble paying dividends. How do you spot and exit those stocks ahead of the crowd?

TIM: You have to see how each company manages its debt. Over the last few years, many corporations have refinanced into long-term fixed-rate debt. These forward-looking companies have locked in the historical low-interest rates on the expense side of their income statements.

Companies that continue to finance their businesses with adjustable rate debt could experience a profit squeeze if they cannot raise their revenues by a similar or better rate of increase. To look for potential dividend cuts, I am focused on companies that have not structured their long-term debt conservatively.

DENNIS: In 2008 when interest rates tanked, trillions of dollars moved from fixed-income investments into the stock market. If interest rates climb quickly, is it possible that investors reverse course, rapidly moving their money back to safe fixed income investments?

TIM: It’s an interesting situation. Interest rates are so low, it would take a massive rise in rates to make fixed income attractive again. I have trouble imagining any scenario in the current economy where long-term rates could jump from the current 2% to, say 5% and attract income investors.

The bond market is much more vulnerable to interest rate increases. Small interest rate increases in long-term bonds can cause large drops in their resale prices, making that asset class quite unattractive.

I can envision a market correction becoming a self-fulfilling exodus as investors discover that index fund investing is not “safe” investing and investor selling forces the ETFs to sell, ratcheting the market downward.

DENNIS: If the exodus (particularly from ETF’s and mutual funds) is rapid, it could cause the pendulum to swing wildly in the opposite direction. That could set up some terrific buying opportunities. Again, spotting those opportunities and acting quickly will become a challenge. Any tips you can pass on to our subscribers?

TIM: While there is some truth in the old saying that all stocks go down like a falling tide in a bad market, I don’t think it is good to generalize. Not all stocks go down, or come back, at the same speed or depth. You need to unbundle things and look more closely.

If interest rates rise, the bond market will suffer. Not only will a bad economy increase defaults, the resale value of existing bonds (many held in funds) will come down quickly as people exit the market.

Stocks that are highly correlated with interest rates and those who have not managed their debt properly will probably take a hit.

If we do go into a recession, not all stocks are equal. Companies that rely on a good economy and consumers spending disposable income are not as likely to thrive as those solid companies providing staples and doing well despite the economy.

The primary investment concern with this approach is to own shares of companies that can sustain their dividend payments through periods of economic or asset valuation challenges.

Fixed rate bonds do not increase their yield. Many solid companies have a historical record of not only paying but also raising their dividends for decades. When the bond market is tanking, there is a lot of capital available and those solid companies are very attractive. That is why, in a downturn, many companies rebound quickly.

It is my job to find those companies for our subscribers, and I advise them not to panic when the market gets emotional. As long as the dividend is safe, they have not lost anything and the stock can come roaring back.

DENNIS: I know you are reviewing your portfolio daily. You issued a sell order for some REITs. Is there a next round of stocks that come to the top of your list?

TIM: I am very much a bottoms-up analyst, reviewing stocks on a company-by-company basis. Every business has its own business plan and varying levels of success from management to realize the goals of those plans. I have yet to discover a shortcut to successful stock market investing, so I spend most of my week reviewing financial results from hundreds of higher yield stocks.

As a measure of defense, I am skewing my recommendations somewhat away from the highest yield stocks and towards stocks with lower yields, but with better prospects of dividend growth.

DENNIS: One last question. The Fed is raising rates and is likely to not renew their bonds as they mature. The latter will also cause interest rates to rise.

Holding on to the right dividend-paying stocks is part of the strategy; however holding cash and having the ability to jump on some real bargains when they appear is the other.

What are you telling your subscribers when it comes to holding cash in reserve? In an emotional market, some good opportunities will arise for those who are willing to act quickly.

TIM: Since each subscriber has a different financial situation, I keep my Dividend Hunter recommendations about cash general in nature. Build positions in new stocks over time and, for those living off their dividend income, retain at least 25% of dividend earnings to reinvest for continued dividend growth.

My Automatic Income Machine service includes a model portfolio that subscribers can use the build their own portfolios and match my investment returns. Currently, the model portfolio is 22% in cash. Since I launched the service, the cash holding has ranged from high teens up to 33%.

DENNIS: Tim thank you again on behalf of our readers.

TIM: My pleasure Dennis.

Dennis here. Retirement investing is a challenging trade-off between preservation of capital (safety) and generating enough income to pay the bills. There really is no alternative; some capital must be at risk in the stock market. As Tim pointed out, risks constantly change and require necessary adjustments.

SSgt. Nunez, my Marine Corps combat training instructor, preached situational awareness; understand what is going on around you at all times, adjust and improvise in order to get the job done. (Why do I remember his name, it was 59 years ago?)

Recognize, understand, adjust and improvise; that’s what generations of people are doing around the world, hoping to retire comfortably.

The enemy of the retiree trying to protect his/her
nest egg is
 complacency.

My job is to make sure that never happens!

An up to date financial plan will help you weather any economic downturn and is certainly far better than no plan at all. A little planning, sprinkled with some good common sense, and minimal financial worries can still provide for a doggone good retirement!

For more detailed information on how to get the job done, you can download my FREE report: 10 Easy Steps To The Ultimate Worry-Free Retirement Plan – by clicking HERE.