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Tue. Oct. 14, 2008

Should You Sell A Dividend Stock After A Dividend Cut? *

I am not a stock trader; I am a dividend and value based long-term buy-and-hold investor. When I add a stock to my dividend portfolio, it is my intention to hold the stock forever. I am not smart enough to time the daily gyrations of the stock market. When stock prices start dropping, our primal instinct of flight kicks in and we want to sell. In many cases that is the time to be buying. However, sometimes selling a stock is the right thing to do.

In determining when to sell a dividend stock, I have one hard and fast rule: When an individual stock held as a dividend investment lowers its dividend, immediately sell it. This may seem like a stringent rule and I have taken a lot of criticism for it from both directions.

Some have said waiting until a stock drops its dividend is too late. There were rumors and innuendos that Bank of America (BAC) was going to drop their dividend some time before it was announced. As it turns out, the rumors were correct this time. However, I can’t (and won’t) base investment decisions on innuendo or rumor.

Others have said that selling a stock after it cuts its dividend is too early. Their argument is the bad news has already been priced into the stock and you are selling into weakness. I feel strongly that an immediate sell is the correct thing to do for the following reasons:

I. Cockroach Theory
When a company that has a long history of raising dividends and suddenly stops, it is usually more than a simple bump in the road. For the one cockroach you have seen (lower dividend) there are probably hundreds waiting to reveal themselves.

II. Adultery Theory
I view a dividend cut as financial infidelity by the company. After a company has raised its dividend 10, 20, 30 or more years that first dividend cut is very hard. Like someone who first has a series of affairs after 30 years of marriage, the first one is guilt ridden, but it is much easier the second time around. Eventually, the guilt goes away. Do you think Citigroup (C) would have the same difficulty cutting its dividend again? In the case of C, I sold part of my position when it became evident that their capital structure could not sustain the company going forward without a substantial cash infusion.

III Experience
My experience has been once a company cuts its dividend, the stock continues down. That has been the case with these that I sold after a dividend cut (prices as of 10/13/08):

  • Washington Mutual Inc. (WM)Sold at $18.11 on 12/11/2007, now worthless
  • Wachovia Corporation (WB) – Sold at $25.89 on 4/15/2008, now $5.85
  • iStar Financial Inc. (SFI) – Sold at $2.32 on 10/3/2008, now $1.46
  • Bank of America Corporation (BAC) – Sold at $28.51 on 10/7/2008, now $22.79

Sure BAC will likely come back over time, but WM and WB will never come back. Even assuming BAC will come back at some point in the future, I likely would have been better to sell, wait for the 30-day wash sale window to clear and buy it back (see IV below on why this is not an option for me.)

IV Portfolio Goals
The most important reason for selling a dividend stock after it cuts its dividend is that the investment is no longer aligned with my dividend portfolio’s goal of building an ever-increasing source of dividend income. Some have argued that certain securities are good value plays after a dividend cut. This may or may not be true, but my dividend portfolio’s primary objective is dividend income, not capital gains. I have a separate portfolio for that. To date, I have not transferred any dividend stocks to my capital appreciation portfolio.

Finally, some will say that it was the “right” thing to do for the company to cut the dividend given the circumstances. In many cases I do not disagree. However, in the cases I have been involved with the company was not “given” the circumstances, they created them through their own actions. If a company was truly a victim of circumstances which couldn’t possibly be foreseen or planned for, I would gladly to cut them some slack and consider an exception to my rule. This situation rarely ever comes along.

Disclosure: No position in any of the aforementioned securities.


9 Responses to “Should You Sell A Dividend Stock After A Dividend Cut? *”

  1. Nurse B, 911 says:

    I think the question always needs to be one of capital preservation. We can focus on dividend stocks, but if a cut indicates that we’ll lose our invested capital even further than you have to protect yourself (no one else will if you’re a DIY’er).

    You can always re-enter the position later if you feel the long-term fundamentals are intact, but I can’t ever fault an investor for protecting themselves from more downside exposure if they feel that’s where the stock is going to go. There are always other opportunities.

  2. Jae Jun says:

    Hahahaha couldn’t help but laugh at the Adultery theory. Will remember that one.

  3. Sport11can says:

    2 questions.

    For the record I am 33 year old canadian investing for the long term… aka retirement.

    1) After investing for the past 8 years in mutual funds (high MER but have done rather well) I have taken the time to read everything I can get and take more control of my investing (my recent 5 year anniversay gift was 2 dividend investing books!! – of course purchased online because they were cheaper!). About 6 months ago I started by purchasing a couple of index ETF’s (VTI, VEA, VWO). Since then I have continued to read and enjoy, and also see the value in, focusing on dividend paying/increasing stocks. I do believe its a better way for me to invest rather than worrying about current prices and trying to tie the market ups/downs (capital gains). So… my first question is that since the indexed ETF purchases don’t really suit my goals now, would you sell them and put the money toward dividend stocks? The caveat is that all 3 are down (approx 35%) given the recent market lows. I’ll add that these ETF’s make up 2% (VTI), 1% (VEA) and 0.5% (VWO) of my total portfolio since I am only managing about 13% of my total portfolio and have switched to buying dividend stocks directly.

    Note: All of my purchases are inside of my RRSP (I am from Canada) so I won’t get any capital losses to claim from a sale.

    2) Do most of you purchase your dividend paying stocks in a taxable account? I have always made all of my purchases inside of my RRSP account since I am in the top income tax bracket and feel I benefit more from the tax break now and don’t have to claim extra income from any dividends received. Do I share this reasoning with anyone else, or do you most of you purhcase in a taxable account?

    Thanks and looking forward to responses and thoughts.

    Maybe this will warrant a whole blog post…. When to cash in to accomplish a Strategy Change?

  4. Dividends4Life says:

    Sport11can: First I am not licensed to give financial advice so i can only share my generic opinion.

    I too am in dividend ETFs and have been unhappy with their performance compared to my individual stock picks. I will likely hold mine for a while longer so as not to make a long-term decision based on short-term information.

    I hald sividend stocks both in my taxable account and my IRA (similar to your RRSP). The contribution limits to the IRA are not high enough to meet my long-term needs.

    Best Wishes,
    D4L

  5. Sport11can says:

    Thanks D4L,

    Mine aren’t dividend focused ETFs but broad indexed funds.

    I am only 33 so I am not really worried about the current market situation, its a great time to buy!

  6. Momma says:

    :) Stumbled you

  7. buyvalue says:

    Great article D4L- some good points in there. I too have often sold after a dividend cut, in retrospect I guess I fall in with the cockroach theory!

  8. Brian says:

    Good post. I’ve been analyzing the dividend investing strategy for a while now. With the recent dividend cuts like Pfizer and GE, I’m beginning to question how individual investors can successfully pick long term dividend growth stocks. I’m sure GE’s cut has hurt many dividend investors. If they sold after the cut, they would have taken huge capital loses.

  9. Brian: It has been my experience that if you don’t sell huge capital losses become enormous capital losses. The key is to limit your exposure to any one stock. Each year you will have winners and losers. The goal is to have more inners than losers over the long haul.

    Best Wishes,
    D4L