It’s OK to Sell Good Stocks

24 Jul 2015 23:34
Tags portfolio prune_ratio

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The Prune Ratio

As an investor you probably have self-implied rules to sell a stock when things are going bad. If a company’s dividend looks to be unsustainable with a possible freeze, cut or elimination then you might sell your shares. If a company has been running a deficit for the last 2 years you might sell your shares.

But would you sell a stock if there was no bad news and the company was the same as when you bought it? If you are new to dividend growth investing this may seem counter to the Buy and Hold mantra you constantly hear. But, as those with experience can tell you, this is nothing more than a general rule or guideline. No single rule can apply to all scenarios. Life just does not work that way. As we gain experience we make supplemental rules to adjust our needs at that given time to accommodate various scenarios.

Normally I preach stock price is secondary to dividend income but in this instance it can represent an opportunity. What if the equity value (capital gain) is growing at a faster pace than dividend growth? In theory, you could sell at a higher value and re-invest in a different stock with a similar dividend growth rate and higher yield resulting in a larger annual return without ever investing any additional money.

This is far from an original thought. Investors for decades have locked in capital gains to reinvest in other opportunities. My problem is the lack of discipline to constantly check when capital gains exceed dividend growth. When I perform semi-annual portfolio analysis I am so focused on looking for alligators I forget to look for opportunities. To help me quickly identify opportunities within my portfolio I have developed a ratio that signals when to investigate a stock that fits this scenario called the “Prune Ratio”.

The Prune Ratio is calculated by dividing your stocks capital gain percentage (CG) by the total dividend growth percentage (DG).

Prune Ratio = CG% / DG%

If the ratio is near or above a value of 4 then I investigate. Why anything above a factor of 4 and not 1? The answer is simple, a factor of 4 represents the minimum significant gain you can achieve while offsetting a capital gains tax and commissions for selling and buying. If you are operating in a tax sheltered account like an IRA or have an offsetting capital loss then you can reduce this factor.

An additional benefit of using the ratio is that it takes the emotion out of selling a winner. I can't speak for all investors but the investors I talk to (myself included) routinely begin a sentence with "If only I sold when it was…". Call it greed, the home run factor, or whatever for some reason it is difficult to sell winners.

Theory Put in Action

To better explain here are three holdings from my portfolio that I will use as examples.

1. People’s United Financial (PBCT)

Bought in 2011 at $12.22/share and annual dividend of $0.63
2015 share price at $16.44/share and annual dividend of $0.67
Share price capital gain = 32%, Total dividend growth = 6.9%
Prune Ratio: 32 / 6.9 = 4.63

This was not a hard one to decide. PBCT’s annual dividend growth is around 1.5% (below my required 7%). What also helped make this an easy decision was that my portfolio was slightly overweight with banks (12% of my portfolio).
I sold all my shares (300) which reduced my exposure to banks to 9%.

I reinvested 2/3 of the proceeds in Omega Healtthcare Investors (OHI) and 1/3 into General Motors (GM) of which both had better dividend growth prospects and better yields.

The Result
Original PBCT annual income $201
New OHI & GM annual income $281
Annual Income Change: +$80

2. Hasbro (HAS)

Bought in 2012 at $37/share and annual dividend of $1.44
2015 share price of $79/share and annual dividend of $1.84
Share price capital gain = 113%, Total dividend growth = 27.7%
Prune Ratio: 113 / 27.7 = 4.03

This one was an extremely hard decision. To start, the average annual dividend growth rate sits at 9% well above my required 7%. While the share price has more than doubled since purchased 3 years ago most of the gains have come in 2015 (it is only July) so it may be an anomaly.

HAS.png

The current dividend yield is 2.31% and finding a new investment with a greater yield is no problem but finding one with as good of a dividend growth rate is extremely difficult.

This one I’m placing on hold to be re-evaluated later in the year to see if the stock price and earnings are stable. If the stock price remains stable I will not sell the entire position due to the attractive dividend growth rate but instead prune it back by selling some shares to capitalize on the gains and reinvest the proceeds to help with income and diversification.

The Result
Annual Income Change: $0

3. Procter & Gamble (PG)

Bought in 2013 at $77/share and annual dividend of $2.40
2015 share price of $80/share and annual dividend of $2.65
Share price total return = 3%, Total Dividend Growth = 10.4%
Prune Ratio: 3 / 10.4 = 0.28

Not much to explain on this one. The Prune Ratio was way below my requirement of 4. The average annual dividend growth sits just below my requirement at 5.8% but PG has been selling off businesses to refocus on core products. I expect dividend growth to start accelerating once again in 2017. The decision here is to leave the investment as-is.

The Result
Annual Income Change: $0

Summary

My initial use of the ratio to evaluate my portfolio was effective in generating an additional $80 a year, improved my portfolio diversification and providing a better growth path for future dividends.

It is still too early to declare a success as time will be needed to validate the ratio. My estimate is I will need at least three years to prove its effectiveness but in the meantime I am pleased with the initial results.

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