“Flying is less scary if you know that you know how to handle an emergency,” my flight instructor once wisely advised me.
Turns out, what he considered flying wisdom would also prove to be investing wisdom. Let’s talk specifically about dividend-oriented investing.
First, when investing in dividends, be wary of selecting a dividend yield that’s too high. A good rule of thumb when making your selection is to use the approximate yield of the 10-year treasury, and then seek no more than twice that yield in dividends. For example, with the 10-year treasury yield about 1.7% as of mid-March 2021, any dividend yield much above 3.5% may be “too high.” I know that level may seem too low and it does not mean to totally avoid higher yielding stocks. I would suggest doing additional research and having a clear reason for owning higher yielding stocks since there may be an additional risk.
It is easy to be drawn to higher yielding stocks. However, it’s important to be wary of stocks that appear to be cheap: their low prices could be due to the company’s outdated products, bad management, expired patents, pending lawsuits, etc. This is where extra research may save the day (and your capital).
Second, don’t let fear of the unknown lead to bad dividend investing decisions. Dividend stocks are generally long-term investments, so in times of uncertainty, selling your stock may not be the answer. How do you know when it’s time to sell your dividend-paying stock? I suggest devoting an hour a month monitoring your stock’s performance using both technical and fundamental analysis to determine if the risk of a potential dividend cut is rising. If a dividend cut looks to be more probable, then it might be time to sell the stock.
Here are three steps to monitor your dividend-paying stocks:
Step 1 (technical analysis): Review a 5-year weekly price chart.
When reviewing a price chart, look for a change in trend from up, or sideways to down. It is widely recognized that stock prices “lead” fundamentals lower. Therefore, a change in trend from up or sideways to down can act as a warning of potential trouble ahead.
Let’s use General Electric as an example. As you can see in the chart below (Figure 1), General Electric dropped beneath the most recent lows in early 2017 at approximately $28.00/per share. Six months later, General Electric cut their dividend in half, at approximately $18 per share (35% lower than the alert price of $28). Ten months later, after General Electric had cut the dividend to 1 cent per share, it was trading at about $10 per share (64% lower than the alert price of $28). As of mid-March 2021, the dividend has not been increased and GE is trading just above $13 – more than 50% below where a change in trend lower gave an initial warning.
5-Year Weekly Price Chart for GE
Figure 1. Source: Schwab.com Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Screenshots are historical in nature. Past performance is no guarantee of future results.
Step 2: Set a price alert on Schwab.com.
Long-term holding, such as dividend paying stocks, should not be sold merely because the price breaks a certain level. Instead, you can set a price alert (Figure 2) to notify you if a certain price level is breached.
Figure 2. Source: Schwab.com. Past performance is no guarantee of future results.
Step 3 (fundamental analysis): If the price alert is triggered, treat it just like an alarm and respond swiftly.
The triggering of the price alert should prompt you to perform a company review using these three key fundamentals:
- Earnings: has earnings growth slowed?
- Revenue: has sales growth slowed?
- Dividend: is the dividend payout ratio rising above 100%?
Note: The dividend payout ratio is measured by the percentage of a company’s earnings per share (EPS), which is paid to shareholders in dividends. Ideally, that ratio should be under 50% for most companies – and you most certainly don’t want to see it rising above 100%. (There are exceptions, such as Real Estate Investment Trusts (REIT’s) and Master Limited Partnerships (MLP’s), which have different accounting rules than regular corporations.)
To see if earnings has slowed, I suggest looking at “GAAP” (Generally Accepted Accounting Principles) only, because this applies a consistent set of accounting rules across all companies. Using this measure compares “apples to apples.”
While the company in the chart below (Figure 3) is not General Electric from early 2017, it provides an example of what you do not want to see when reviewing earnings and sales growth.
Figure 3. Source: Schwab.com. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Screenshots are historical in nature. Past performance is no guarantee of future results.
Now looking at dividends: the chart below is from March 2021 and the dividend payout ratio is a reasonable 19% (Figure 4), However, in this same chart from September 2019 (not shown), General Electric had no payout ratio due to negative earnings. In this case, you might want to consider selling the stock rather than waiting for the price to rally.
Figure 4. Source: Schwab.com. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Screenshots are historical in nature. Past performance is no guarantee of future results.
To put it another way, the co-authors did a review of 1,000 stocks compromising the Russell 1000 Index (RUI) from January 2010 to December 2020, in a market where dividend cuts were generally rare until COVID hit the economy in 2020. This data provides statistical validity that stock price generally trends down significantly prior to a large dividend cut and continues lower after a large dividend cut. (See below for notes.)
|Dividend Change||Median 12 month price return before announcement||Median 3 month price return after announcement||Median Adjusted Dividend Payout Ratio before announcement||Median Dividend Yield before announcement||Percent with negative EPS before announcement||Count of occurrences|
|Stay the Same||10%||2%||44%||2%||10%||26,127|
Figure 5. Source: Schwab Center for Financial Research. Past performance is no guarantee of future results.
Note: This table groups dividend paying stocks from the Russell 1000 Index into buckets based on the change in their dividend. Stocks were monitored from 2010 to 2020. Stocks with a dividend cut of 20% or more were grouped into the bucket labeled "Big Cut.” Stocks with a big cut in their dividend had a median stock price decline of 14% before the announcement of the cut and the stock price continued to fall by a median of 15% in the quarter after the announcement. These companies had a median adjusted dividend payout ratio of 100%. When earnings are negative, the dividend payout ratio loses meaning, so it was adjusted to be 100% for those stocks with negative earnings. In contrast, stocks that raised their dividend by 20% or more (grouped into the bucket "Big Raise") had a median price return of 20% in the year before the announcement, continued to appreciate after the announcement, and had a dividend payout ratio of just 23%. Compared to stocks that raised their dividend, stocks that cut their dividend had higher dividend yields and were more likely to have negative earnings.
The bottom line
Consider using a trend-following approach to technical analysis and setting price alerts on Schwab.com to initiate a review of the company’s fundamentals. If those fundamentals are deteriorating, especially if the dividend payout ratio rises above 100% of earnings, then give serious consideration to selling the stock in an effort to avoid a potential dividend cut.
Adopting this method as part of your trade strategy may give you peace of mind, because you’ll have the tools and resources to help you determine when it’s time to sell. If you need additional help to keep you on track with your long term investing goals, you may want to consider enlisting a financial professional to help manage your dividend stock portfolio.