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Wed. Feb. 4, 2009

The Dividend Stock Life Cycle *

The renewing of life. There is nothing more natural than the live birth of a child. In this birth there is life, hope, unlimited potential, and yes, eventually death. Though we don’t like to focus on it, death is just as natural as birth. In much the same way, it is natural for a percentage of dividend stocks to fail each year, either in not raising their dividend or literally ceasing to exist. As we plan for out own death by buying life insurance and making final arrangements, we must have a plan in place for when inevitable happens and we must sell an under-performing dividend investment.

Dividend investors are looking for solid companies that consistently grow their dividends. Last week Pfizer Inc. (PFE) cut its dividend by 50%, and as such is no longer suitable for my dividend portfolio. The quandary faced when selling a stock after a dividend cut is replacing the lost income without assuming undue risk. As with most stocks, PFE’s price had declined over time and the stock was yielding over 7% prior to the dividend cut announcement. Immediately, after the announcement the stock dropped 7% and was only yielding around 4%. Fewer dollars are now available to replace income from the previous higher yield. So what do you do to replace this income without assuming unreasonable risk?

Fortunately, I had built up a risk reserve by purchasing lower risk stocks and trimming my positions in higher risk investments over the last several months. My portfolio was poised to take additional risk, but I limited the risk to the amount needed to replace the lost income. This was done in a two step process:

  1. With the cash received from the PFE sale, I purchased shares of Eli Lilly and Co (LLY) to help preserve my sector allocation. At the time, LLY was yielding slightly over 5% and was rated less risky than PFE prior to the announcement. This dividend income from this purchase fell well short of that lost from the PFE sale.
  2. With limited funds available, I had to assume additional risk to get yield needed to maintain the prior level of dividend income. To accomplish this, I opted to purchase a small block of CenturyTel Inc (CTL) yielding around 10%.

PFE and CTL were both classified as high risk stocks and each had the exactly same risk rating. With LLY classified as a medium risk stock, I now had fewer dollars in the higher risk category, thus the overall risk of my portfolio is now lower and I am earning slightly more dividend income. There are good and bad ways to increase your portfolio’s return. As the old saying goes, when life hands you lemons, choose to make lemonade.

(Photo Credit)


4 Responses to “The Dividend Stock Life Cycle *”

  1. VLT says:

    I found your article on the Dividend Life Cycle very interesting–so do you consider it a general rule that whenever the dividend is cut–sell the position?

    Thanks

  2. VLT: Selling after a dividend cut is my one hard and fast rule. Here is a post on it: Should You Sell A Dividend Stock After A Dividend Cut?

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