What to Do When Your Dividend Stock Zips Ahead

How to decide whether to hold or reinvest after a big run-up.

What do you do when your dividend stock goes up faster than you ever hoped? It’s a nice problem to have, but it can be a problem, nonetheless.

Imagine that Amalgamated Zipper (NDAQ: PULL) catches your eye. The company has a solid balance sheet. It is steadily winning market share thanks to zipper innovations under a dynamic, visionary CEO. The yield is 4%, nicely above the market average, and you think the company will be able to raise that payment over time. You add it to your portfolio.

A few years pass, during which AmZip steadily increases its dividend by 50% in total. Your yield to cost is up to 6%. Everything is going according to plan.

However, imagine something much more exciting has happened along the way — AmZip’s shares have sky-rocketed. Buttons have been outlawed, and that means zippers are up, up, up! How far up? It’s all imaginary, so let’s pick a very high number. Your investment has gone up 400%. What luck!

What do you do now? You bought AmZip for income, and it has done its job in that regard, paying dividends steadily and increasing the payment over time. The problem is that it’s hardly much of an income play at this much higher level. The current yield is just 1.2%. You probably wouldn’t get interested in a dividend stock with such a low yield. Why continue to own something you wouldn’t buy with fresh money?

You’ve heard you’re supposed to let your winners run, but the skeptics are saying that zipper stocks are too risky. They’re overvalued. The anti-button laws could be repealed. More companies could enter the zipper industry. A guy tooling around in his garage could invent a new and better way of joining fabrics, making zippers obsolete. Perhaps Velcro is gaining market share. Meanwhile, the bulls say the skeptics are losers. They’ve probably been shorting zipper stocks for years.

Just wait until a new generation of autonomous zippers come out next year. Then the rally will really gain steam.

In the face of all this “information,” you don’t know whom to believe. What do you do with your suddenly oversized position in AmZip?

It’s worth considering the tax consequences of selling. Depending on your tax bracket and holding period, you might have to pay 20% capital gains tax on 80% of the proceeds, a 16% haircut compared to a world where AmZip becomes part of your estate and your heirs get stepped-up cost basis.

Then again, if you accepted the 16% discount and reinvested in something else yielding 4%, then you could nearly triple your income compared to what AmZip is now priced to yield.

As for AmZip, don’t just look at the yield in isolation. Instead, step back and ask the same questions you’d use in any good stock study:

• Are sales and earnings still growing at a healthy pace?

• Does the dividend look sustainable?

• How does today’s price compare with a reasonable value range for a business of this quality?

Also check how big AmZip has become in your portfolio so you’re not letting one stock dominate future results.

Only after looking at those fundamentals, valuation and position size should you decide whether it makes sense to keep riding this winner or trade it for a higher-yielding opportunity.

After weighing all these factors, if income is your primary objective and the growth story doesn’t justify the low yield, sell and invest in something priced to yield more. Try to forget that you ever owned AmZip in the first place.

Then if the cheerleaders are right and it goes up even more you won’t feel any regret for selling. You had a thesis that AmZip would pay you a nice, steady income, and while you’ve been right all along, the game has changed.

If you keep holding on at the much lower yield, then you’re submitting to “thesis creep”, which means you’re coming up with excuses not to act on an investment that has veered off course (however positively).

Don’t let your dividend portfolio morph into growth portfolio. If you’re not prepared to sell a big winner from time to time, then why are you picking your own stocks in the first place?

Dividend investing differs from growth investing in many ways. One is that the old maxim of “buy low, sell high” is much easier to apply when chasing income.

There are plenty of opportunities out there for the active investor, but you have to play the game the right way.

There’s something to be said for letting winners run, but there’s also something to be said for recognizing good fortune when it comes along.

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Dividend Informer delivers regular research and analysis on securities which provide a combination of income and long-term appreciation, aiming to reduce volatility while still delivering adequate investment returns. Each month, our professional stock analysts publish detailed, high-quality, income-oriented stock ideas for subscribers. These in-depth research reports are exclusive to the Dividend Informer newsletter.

In Dividend Informer you will discover actionable opportunities for your portfolio, through investing in growing companies with a track record of offering regular, increasing capital return in addition to potential for share price growth.

Our focus is on reasonably-valued companies with solid balance sheets and significant free cash flow generation, allowing for the payment of consistent, growing dividends.

A heavy emphasis is placed on dividend yield, of course, but the newsletter is not focused on current income but long-term total return. Often we highlight companies returning significant capital to shareholders via share repurchases and debt reduction.