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Three Reasons Why You Should Sell a Dividend Stock
Investors buy dividend stocks for the long term with a view to generate passive income that supplements their retirement or other income. Dividend stocks have the tendency to appreciate in value over the long term while providing dividend income to investors so as to support their personal finance goals. Recently we received an email from Eric J. Fox who describes why he likes to buy dividend paying stocks. He quotes, "One reason I was taught to buy dividend paying stocks was this: the long term return on the stock market was 8-10% so if you could get half that return in dividends then you were that much closer to achieving that return."
Other reasons why investors like to buy dividend stocks is because their income from investing in certificates of deposit (CDs) or government bonds yields very low interest; it would be hard for you to make more than 3% on a US Treasury bond even if you were willing to lock your money for 5 years. So investors are so eager to buy dividend generating stocks, why would they think of selling such investments that generate them relatively higher incomes? We explore 3 reasons why:
i) Reason 1 - Dividend Cuts
If investors buy high yielding dividend stocks in an effort to generate income in the form of streams of dividend payments, but the company one day decides to reduce or cut its dividend altogether, then for those investors, there will be no point of holding that stock. This will put selling pressure on the stock and downward price movement. Here's an example of a dividend cut by General Electric.
General Electric on 27th February, 2010 decided to cut its dividend from $0.31 per share to $0.10 per share in an effort to save $8.7 billion dollars in cash each year. This was done so as to have enough cash on hand to inject a capital investment to their finance subsidiary, GE Capital which is suffering from the financial economic downturn in the United States. Investors did not really like this news and GE stock was down -1.48% that day.
ii) Drastic Change in Company's Strategy or Management
Sometimes a dividend paying stock that you own may be taken over with hostility by another company and current management is replaced with new management, whom you do not really know very well. Or, the company may be making mergers & acquisitions thus increasing their long term debt beyond levels you do not like. Another reason could be the industry the company operates in is undergoing major change or extinction, for instance Verizon at one point in time was considered a doomed company because of its landline business. However, the company has now shifted its business model to cater for the wireless business, hence Verizon Wireless (VZ) is still in business! These are some of the reasons why you would sell a dividend paying company that is undergoing major change.
iii) The Company's Stock is Overpriced (Price to Earnings Ratio)
If a company's stock has risen too high in the stock market but earnings are not growing or are stagnant, then this goes against the fundamentals of investing in stock markets. For instance, if a company's price/earnings ratio increases from 22.25 to 28.45 while the earnings are still the same, this indicates to investors the stock has risen a lot in value while the company's business has not really grown. At this stage in your investing career, you would be advised to sell the stock while it is riding high, and when it pulls back due to a market correction (if it pulls back to 22 - 24 P/E ratio), you would buy some more.