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Trade my lower yield stocks for higher yielders and maybe sell my winners for losers? No Way!

Publication Date: 04 Sep 2018 - By Mark Morelli By Mark Morelli
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Macro Equity Fundamental Equity USA

One of my personal pet peeves is when an investing pundit advocates selling low yield stocks (and in this market most likely a winner) and buying higher yielders (which might translate into being a loser in the portfolio). Their stated goal is to create a higher income stream.

Is that a wise strategy? One well-known investor, economics professor, and author says no. Simple math for my own situation also says no.

A random walk might lead to random results

Famed investor and college professor Burton G. Malkiel is probably best known for his "Random Walk Down Wall Street" books. His take on this issue can be summed up in a series of quotes:

“Psychologists also remind us that investors are far more distressed by losses than they are delighted by gains. This leads people to discard their winners if they need cash and hold onto their losers because they don’t want to recognize or admit that they made a mistake. Remember: Selling winners means paying capital gains taxes while selling losers can produce tax deductions. So if you need to sell, sell your losers. At least that way you get a tax deduction rather than an increase in your tax liability.”

“Put time on your side. Start saving early and save regularly. Live modestly and don't touch the money that's been set aside.”

My interpretation is the following: There's a reason that you hold winners and (maybe) losers in your portfolio. The stocks you have that are up were of the higher quality and those that are down are not. Why would you want to get rid of the higher quality stocks and hold onto (or buy) those of lower quality? It makes no sense. 

Trade low for high?

It is likely that the yield on some of your dividend growth stocks has sunk into the "low yield" or "moderate yield" range due to the effects of price gains during the current bull market and a slowdown (until recently) in dividend growth. In the case of some of the losing stocks it might be "accidental" due to a significant drop in the price based upon a change in fundamentals or other factors such as the Amazon (NASDAQ:AMZN) effect in the retail industry. 

Is the trading strategy wise at this time?

I'll use my own 22-position (20 stocks) portfolio as a guide. Note that 19 of the stocks (21 positions) were purchased with the dividend in mind and one, Apple, Inc. (NASDAQ:AAPL), was not dividend-focused, although shortly after Apple reinstituted its dividend the yield was relatively competitive (2.4% in August 2013).

For me, I define low yield stocks as those that have a yield less than 1.5x that of the overall market and moderate yield stocks as those that yield between 1.5x and 2.5x that of the market. High yield stocks have a yield greater than 2.5x that of the market.

Currently I will buy (including reinvesting dividends and adding new capital) shares of companies only in the moderate or high yield categories. This tactic also acts as a defacto valuation exercise (as the moderate and high yielders might not have "gotten too far ahead of themselves price-wise" yet). 

However, I'm not inclined to sell a winning stock to try to squeeze out a few extra dollars of dividend income.

Currently the S&P500 index yields about 1.75% so my low yield stocks pay out < 2.625% and my moderate yield stocks pay out between 2.625% and 4.375%. My high yield stocks pay out greater than 4.375%. 

My portfolio has the following breakdown (as of Aug. 24, 2018):

Yield Category

# Positions

Low (< 2.625%)

9

Moderate (2.625% to 4.375%)

9

High (> 4.375%)

4

My portfolio has a weighted average yield of 2.53% (overall in the "low" category) and a dividend growth rate of 11.9% (which is significantly faster than the overall market long term average of 6%). 

Some might say that the nine stocks in the "low yield" range might be good candidates for swapping out for higher yielders. Some might also say that some in the moderate yield category would be candidates too. 

Six of the low yield stocks are in a taxable account and three are in a tax-deferred account.

I'll tackle the six stocks in the taxable account first. If I sold those and bought higher yielders I'd be on the hook for a significant tax hit. On paper I'm up well over $100,000 on those positions and assuming I'd be in the 22% tax bracket I'd have to pay more than $15,000 in LT capital gains taxes and all of my qualified dividends would be subject to taxation (right now I avoid taxes on qualified dividends). It would also mess up my overall long-term tax planning process. If I swapped only 3 of the 6 it still could result in a big tax hit.

Even if I was to find similar quality stocks (a big "if") that yield 1.5x to 2x higher it might take me several years to make up for the tax hit assuming a similar dividend growth rate. And usually higher yielders have slower growth. That would push out the breakeven point even further. And there is no guarantee that the new stocks selected would be of the same or higher quality and provide the needed safe income.  

Regarding the three stocks in the tax deferred accounts, one, United Technologies Corp (NYSE:UTX), is in my 401k and I wouldn't be able to buy another publicly traded, individual stock to replace it. I'm only allowed to own my former employer's stock or index/mutual funds there. The other two stocks have combined dividend payments of about $500 per year. Even if I was to double the yield the extra $500 per year is a rounding error in my portfolio. 

Conclusion

It might be prudent for many dividend growth investors to take a step back (and do the math) before taking the plunge into trading low for high yielders.

You might be taking a random walk into random results.

Disclosure:

I have positions in the securities referenced in the contribution

I do not use any non-public, material information in this contribution

To the best of my knowledge, the views expressed in this contribution comply with UK law

I agree with the terms and conditions of ReachX

This contribution is for informational purpose and does not constitute investment advice nor is it an offer to sell or buy, nor is it a recommendation for any security.

Mark Morelli

 

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