There's a lot to like about dividend-paying stocks. Among other things, they provide you with real cash returns that give you the choice of what to do with a slice of the company's profits and offer an inflation hedge when payouts increase. Additionally, dividend-paying firms make less cash available for executives to "empire build" or take on value-destroying projects, which can actually improve long-term profit growth.
On the other hand, over the past two years, we've seen the worst side of dividends -- cuts, eliminations, and suspensions. In the S&P 500, 62 companies cut their dividends in 2008, followed by another 90 in 2009, including Bank of America and Morgan Stanley. In 2009 alone, companies eliminated $58 billion in dividend payments to shareholders.
Suffice it to say many dividend-based strategies were turned upside-down, including one of my own.
Fool me once ...
No one wants to get fooled (lower case "f") again, of course, but trading in and out of dividend-paying stocks doesn't make much sense, either. Instead, here are five scenarios where a long-term, income-minded investor should consider selling a dividend stock.
1. The dividend is cut or suspended
This is the most obvious reason to sell. Even if a cut is good for the business long-term, it could take years, if ever, before the dividend returns to its pre-cut levels. Pfizer
The downside to selling after a dividend cut is that you're often selling at depressed prices. Before you decide to sell, make sure you have a better place to move your funds.
2. The company can't afford its debt
Common stock owners rank lower than creditors on the totem pole. If the company doesn't generate enough profits to cover its interest payments, it's time to get suspicious of the dividend. According to Capital IQ, 86 U.S.-based dividend-paying firms had market caps greater than $1 billion and interest coverage ratios (EBIT/interest expenses) below 2 in January 2008; 42 of them have since cut their dividend.
3. Free cash flow dries up
Dividends are only sustainable if the firm generates more than enough free cash flow to cover the payouts. In 2007, International Paper
Today, International Paper's dividend is half what it once was, but the company at least generates more than enough free cash flow to cover it, thanks in part to greatly reduced capital expenditures and acquisition spending.
4. You no longer understand the business
A company you bought way back when may not be the same company it is today. If you no longer understand what makes it tick, it's best to get out. An October 2008 article in the Wall Street Journal highlighted an unfortunate case of an elderly investor whose retirement plan was crushed by Wachovia's dividend cut. Her husband had purchased shares of their hometown bank years earlier; it was subsequently acquired by Wachovia.
Understanding the ins and outs of a local community bank is one thing, but a multiregional financial conglomerate rife with exotic mortgages is something else. A number of Wall Street analysts didn't fully understand Wachovia, either -- Merrill Lynch upgraded the shares in July 2008, just three months before it was forced by the FDIC to sell to Wells Fargo.
5. There's a better alternative
It's very easy to get emotionally tied to stocks that have paid you back year after year, but in some cases, you could do even better with other stocks. To illustrate, if you bought $10,000 worth of Deere
However, Deere's current dividend yield is just 1.6% and the stock is trading at or near five-year highs in terms of price-to-earnings and price-to-book ratios. Meanwhile there are plenty of fine dividend stocks yielding more than 3% today. If your objective is income generation, you could consider selling your Deere shares and rolling the proceeds into a quality stock paying 3%, thus increasing your annual dividend income to $1,830. Alternatively, if you sold half your Deere stake to diversify, your new annual income would be $1,401. As always, be mindful of tax implications when selling stocks for a considerable gain.
Two potential substitutes to consider today are Chevron
It's strictly business
Despite the myriad benefits of dividend-paying stocks, at the end of the day, they're still stocks. As such you need to periodically review them to ensure they're the best place for your money. Dividends, after all, are a privilege, not a right. As the events of the past two years have reminded us, they're not reason enough to hang onto a stock.
Having a set of reasons to sell a dividend stock, then, is just as important as having a set of reasons to buy. It helps you become a more disciplined investor, even if your favorite holding period is forever.
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This article was originally published on May 6, 2010. It has been updated.
Fool analyst Todd Wenning is hoping the Cincinnati Reds can go at least .500 this year. He does not own shares of any company mentioned. Pfizer is a Motley Fool Inside Value choice. Automatic Data Processing and Chevron are Motley Fool Income Investor recommendations.
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