The Dividend Cafe - When Is It Time to Sell?

Episode Date: August 26, 2022

Long-time readers of Dividend Cafe know that the real intent of this weekly commentary is to delve into the macroeconomic – the big picture – the high-level stuff that impacts investor decisions and behavior. Today in honor of the obsession over Jerome Powell’s speech at Jackson Hole (being delivered shortly after I hit “submit” on this commentary), I want to talk not an iota about the Fed, monetary policy, or really any aspect of macroeconomics. Rather, I want to actually dive into a question that is hyper-practical – more micro than macro – and that is when to sell a stock. I was in the process of answering a question about this topic for the Ask David section of The DC Today when I realized it really warranted the full Dividend Cafe treatment. So here we are – a Fed-free Dividend Cafe dedicated to the ever-practical issue of sell discipline. We’ll discuss Jackson Hole in Monday’s DC Today (only because I have to), but for today let’s talk about how dividend growth equity investors like ourselves think about the right time to sell a stock. Let’s jump into the Dividend Cafe … Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to the Dividend Cafe. I am very purposely driving a Dividend Cafe message today about something that has nothing to do with Jackson Hole or the Fed or Jerome Powell or monetary policy. We talk about monetary policy. We talk about long-term ramifications, macroeconomic reality around monetary policy ramifications all the time. So I'm not boycotting it this week because I've decided I no longer want to discuss

it. It is a multi-year, multi-decade interest to us. The particulars today are not of much interest to us. What one speech is about and what the immediate trader's reaction is and so forth, immediate trader's reaction is and so forth. These things, I think, are media moments. And I don't think anybody cares what posture I take about it or stance I have or anything like that. But there is a sense in which I just want Dividend Cafe to be better than that. I don't want Dividend Cafe to be pulled around by a headline of a given day, particularly one like this that is just so ridiculously forecastable, predictable, and known, and you deal with the aftermath of traders. But this idea that Jackson Hole is supposed to be this paradigm-setting moment and a speech that a Fed chair gives, which is just

completely, totally consensus, like exactly in line with everything anybody would have expected. It bothers me. And so I said, okay, well, great. I now have a dividend cafe that's going to go in a whole nother direction. The world's my oyster, what I want to do. Quick backdrop is I got a question in the Ask David section of the DC Today. For those listening to the podcast who don't read the DC Today, we do a daily market summary every day, Monday through Thursday. Friday is when we put out Dividend Cafe. So we do this daily market summary Monday through Thursday, Friday is when we put out Dividend Cafe. So we do this daily market summary Monday through Thursday in written form.

It comes into your inbox. It's posted to social media. It's posted to our website at the dctoday.com. And I think that there may be some of you who watch the Dividend Cafe video or listen to the podcast who don't receive it. Maybe some of you who watch the Dividend Cafe video or listen to the podcast who don't receive it. We don't, unfortunately, do the daily in a podcast form. Maybe we should. I was doing it during the COVID moment, which is kind of why I don't now, because it was so labor intensive and challenging with scheduling logistics. You know, our production team works extremely hard, but there's a kind of limit

to all the things we can do daily. But look, the podcast format is growing, and maybe it's something we have to consider. But all I want to do is mention that the written DC Today is something you might want to think about. Well, we do an Ask David section in there because we get an awful lot of questions that come in, and I try to interact with those questions every day in that format. And one of the questions, back to the subject of today's Dividend Cafe, is when do you guys sell a stock? You talk a lot about why you buy companies, what your thesis for ownership is, but what does your sell process look like? I thought it was a good question. I think it's worthy of an answer and I want to be able to address it today. Let me first start with a kind of higher level overview of something. Our firm's a little bit unique in the investment advisor community these

days in that we don't outsource investment decision making to kind of a third party platform. There are a significant amount of turnkey third party platforms that you can just plug and play, turn over a client account to, and then they go in and create a kind of model asset allocation. And so this third party platform is both allocating what the weightings may be to stocks and bonds and other things, but also selecting the ETFs or the managers or the mutual funds or whatever fit within it. And we don't do that. And there's reasons we don't frankly believe in it. But what I am referring to in this question about when we sell is in regards to specific stocks. And the distinction here is this.

Our firm allocates, makes all of the allocation decisions for every client in-house on a custom basis. But we don't do that based on three different preset models. We don't do that based on three different preset models. We have complete and total advisor by advisor, client by client flexibility on what percentages we want to allocate to the various categories of investing that we believe in. And I think this is an important distinction. I have done a Dividend Cafe on it before, and we did a lot of client communiques when we sort of systematized our operation magnify a couple of years ago now. More or less, we don't believe that small cap growth is one asset class and international equity is another asset class. We believe that they are distinct and that one's international

and one may be domestic and one may be domestic and one may be small cap and one may not. But we think that's totally immaterial to a client. We created our asset categories and classifications around their unique and distinct risk characteristics, reward objectives, income, growth, the liquidity realities, what they mean to a given client, why a client may own a certain asset category or not. And so for us, just real quickly, because I don't want to turn the podcast into a recap of Magnify, but our asset classifications are core dividend equity, which is where we're

going to come back to in a moment, boring bonds, credit, growth enhancements, income enhancements, alternatives, and directs or illiquids, okay? Very bespoke type of direct investing. The fact of the matter is each one of those is highly distinct and has certain characteristics that make it different from one another. And there's a real method of madness of why we believe that is the right way to classify different assets, to think about assets, to monitor a portfolio, and so forth. There is a reason why some clients should have no boring bonds. There's a reason why some clients should have a large weighting in income enhancements. And so this idea of a style box where someone's supposed to care about small, mid, large capitalization, you own small cap

growth stocks for capital appreciation over time. You own international equity for capital appreciation over time. And the vehicles you're using within those to get that may be good, may be bad. There's tactical considerations. But the point is they're not distinct to the client and their objective, where what you own boring bonds for is different than what you own core dividend stocks for. So there was a reason why we magnified our asset allocation process around these seven building blocks. The reason I bring that up is the sell discipline we're talking about, the question of when we sell a stock, is not when we move from some bonds to more alternatives or when we sell from a certain amount of growth

enhancements to more dividend equity, weighting shifts within an allocation, there is an answer to that, but that's not the subject of this Dividend Cafe. The one or two sentence summary is it's usually valuation driven or client circumstance driven. But I'll leave it there. We're also not talking about selling, meaning we want to be in the market or out of the market. Market timing. We believe that's a fool's errand. I've again also talked about this subject a lot.

I guess it's a joke. I don't know. I say it kind of seriously, but I'm meaning it to be funny. So is that a joke? I don't know what that's called. The only people that I think time the market well are liars. And there is a challenge when you believe, as we do at the Bonson Group, that the fundamental driver and determinant of investor success over time is behavior, that market timing really feeds opportunity for bad behavior.

And the propensity to wrongly time an exit and then have to figure out a time for reentry and then to get stuck in the vicious cycle of regret. These are things we've seen play out so many times and can be so fatal to a given investor that we find it really, really foolish. Not to mention essentially impossible to do. So we're not referring to that because we do not believe in it. What we are referring to is within that asset class that we call core dividend, which is, by the way, the largest asset class we allocate to. It is our favorite building

block of a portfolio. We have clients that might have 70% weighted into it and other clients who might only have 30% weighted into it. But my point is on a custom basis, we figured out what might make sense based on a client's appetite for volatility, their liquidity needs, their income needs in the present or the future. There's a lot of circumstances that may go into that particular weighting. First and foremost would be the tolerance for volatility because dividend equity is by definition the stock market and the stock market possesses certain up and down movement realities that have to be measured for their propriety client by client. But within that

we are actively managing. Like the asset allocation decisions, we also do not outsource the portfolio management of the dividend equity. We do outsource the individual bond selection of boring bonds, but that's because that asset class bores us to tears. And for the most part, only communists manage bonds anyways, but I'm just kidding, sort of. The fact of the matter is that dividend equity is what we do, what we think we do well, what we believe in. And so this question, this entire setup about sell discipline comes down to when we might want to sell a stock within that asset class.

It's a little bit over half of the roughly $4 billion that we're managing. And we have the resources in-house, our traders, our analysts, our investment committee. This is a very proprietary process when we have a lot of accountability around, ownership of, and consequently skin in the game. around, ownership of, and consequently skin in the game. So when to sell a stock for a dividend growth investor, I will start with two different premises that I want you to remember. One is that in a perfect world, the ideal time, I'm paraphrasing a bit from Warren Buffett here, in a perfect world, ideal time to sell a stock that is repeatedly and consistently and reliably growing their dividend is never. And premise number two is that it's not a perfect world. And so I believe that

a perfect world. And so I believe that reconciling that tension and managing around that tension is our burden, is what our responsibility is. Effectively, the need to sell when we do our due diligence right prior to a purchase is probably heavily mitigated, but never perfectly or completely mitigated. Facts change and theses for ownership can be wrong. So there's a fallibility that could cause one to need to move on. There is a reality to creative destruction to the nature of a free enterprise system that some circumstances can change. Now, again, I really do believe that a culture of a company, a history, the uniqueness of a business model, the character of free cash flow generation, the capital intensity dynamic in a company, the balance sheet itself, cash on hand, net cash, meaning cash net of debt, the cost of servicing various debts, how a capital structure exists across short, mid, and long-term debt term structures. There's so many factors that go in quantitatively and qualitatively into dividend sustainability. But there also are companies that have behaved

incredibly well and executed incredibly well for many, many, many years with a reliably growing dividend and then things did change. And so we do feel the need to constantly be monitoring our outlook on dividend sustainability and when our outlook on dividend sustainability changes to potentially need to sell. There are a few different high profile sale events in the history of our company that proved incredibly prescient. Companies that, in some cases, I really didn't want to sell but just believed we needed to. There are, I'm going to say, five or six situations that we were really vindicated for. Like we made a very good decision and in some cases made a very out of favor decision.

At the time we saw writing on the wall about dividend, the market didn't necessarily agree with us. But one of the situations that became kind of a career marker for me and a very vital moment in my beliefs about portfolio management was the case, there's a really large global superpower bank called Citigroup, and it was a huge position for us in 2007 going up into the financial crisis. And at that time, the stock was down a little bit as the housing market was starting to weaken.

But a lot of those big banks, their stocks were down, which meant their dividend yields looked higher, and it seemed very attractive. Why would you want to sell a stock that's dividend yields now got up to 5%, 6%, 7%? But qualitatively, there was a lot of reason to be skeptical about the dividend sustainability. And this is all well before the financial crisis. Everyone knew at the time of the financial crisis, the dividend was gone. The question is whether or not the furniture was even going to be there anymore. Forget the dividend, right? most of these big banks were doing from foreign entities at really high coupons

just to meet their liquidity needs because of what was the early innings of this massive financial deterioration. And yet at the same time sustaining the dividend, it was an exercise in negligence and foolishness that may not ever be repeated again in Wall Street lore. It was just so insane. So to sell a stock at $50 and then have it a year later below $1 and 15 years later, split adjusted, because there's splits in there that can screw things up, but split adjusted, it's down like 92, 93% from where it was sold. 15 years later, that was not about seeing a financial crisis coming. That was not about seeing a stock about to drop.

It was about lack of confidence in dividend sustainability. And in that case, it most certainly spoke to something that proved to be a really, really big narrative. But, you know, a lot of other big Wall Street firms are at pre-crisis highs. They kept their dividend going. They had a period they had to hold it because of the Fed and regulation and TARP and other things that came about in 2009. But my point was, you can just sort of look at the dividend reality and some of these individual companies, and there was a lot of reward for those who did that analysis. But over the years, whether it's a giant telecom company or media company or energy company, various decisions to sell.

For us, we're never based on anything other than dividend outlook. And I want to make clear, there are times, I don't think there's very many, but there's one that always will stick out for me of a senior care REIT that I believe was very vulnerable around their dividend. We made the decision to cut, and they were able to refinance some things in their capital structure, and they preserved their dividend. Their stock price did go higher. The dividend didn't get cut. And so our defensive posture in that case led to a decision that didn't come to fruition, and I would not have done anything different based on the facts we had at the time. But that was the thinking. The decision to sell was always and forever dividend growth driven.

Do we believe this company has the ability to sustain its dividend? Now, the caveat I do need to give before I wrap us up here is there are times that we will trim a company that we have no fear at all is about to cut their dividend. And here, understand the difference between a trim and a sell. We might be selling a company because we believe it has gotten totally excessively expensive or is vulnerable to a dividend cut. But we may be trimming a company, meaning bringing a weighting down, like it was 4% of our portfolio or 3% and now we're bringing it to 2% because circumstances have allowed us to believe that there's an opportunity elsewhere

and we want to free up cash from the gains of a certain position and go into where there may be a better opportunity. But I want you to do a little math real quickly when you think through this. If you buy a stock at $50 and it's paying a $2 dividend, that's a 4% yield at purchase. And if 10 years later that stock's at $150 and is paying a $4 dividend, your dividend yield went from 4% to 2.6%. Of course, the stock has tripled and the dividend has doubled, but the dividend yield is now lower. And so it may be that the opportunity set means you lower that weighting a bit. You have no projection of them cutting the dividend. You have no projection of the dividend growth not being sustained. But at that vantage point, there is a excess capital you've created through real value creation inside the portfolio that can be redirected

into another opportunity where at purchase, perhaps you have another opportunity to buy a 4% yielder that also has 10% per year dividend growth in front of it or whatever the case may be. So trimming for opportunity reasons is another caveat, but it's different than a sell discipline. I hope that distinction makes sense. The entire beauty of a dividend and dividend growth investment is we do try to eliminate arbitrariness. There is qualitative and, of course, quantitative assessments that go in. There is qualitative and, of course, quantitative assessments that go in.

But we believe a dividend is a cause and an effect in a good investor outcome. What I mean is the cause, you're actually receiving money, you're receiving a reward. It's a cause of investor return, but it's also an effect. The dividend comes from value creation happening within a business, within an enterprise. There's growth of profits. So real wealth creation. And then the effect is there's more money to distribute to the shareholder. So the dividend has this pro-cyclical virtue to it, being a cause and an effect in an investor portfolio. Do we want to sell a company because it's up?

Never. Do we ever want to sell a company because it's down? Never. Now, that's different than saying we wouldn't sell when a company is up or we wouldn't sell when it's down. It's just the reasoning, the motivator, the driver. Selling because a company is up makes absolutely no sense. Your gain at the time in which you may be selling or not selling a position,

and by the way, your gain or your loss, is totally immaterial. All it does is speak to a past moment, which is what? The price at which you bought it. The circumstances of the company at the time you bought it. All that matters in the present is the present and the future. And so there are companies that could be up 5,000% from when you bought it that are cheap. And there could be companies that are down 50% from where you bought it that are expensive. I could think of a few that many people hold right now. And so I think that the psychology of investing that makes us believe what we paid for a stock

is relevant to the stock itself is a little bit arrogant. The stock doesn't care what you paid for it. Stocks are viciously forward-looking mechanisms. And yet, so much of our psychology and emotional appetite centers around our experience with a given stock as opposed to a forward outlook, which we can divorce from arbitrariness, from momentum, from speculation, from anticipation of multiple expansion or contraction, and focus on something far more objective, far more sensible of a criteria, which is the dividend growth that comes from free cash flow generation. So I love the idea of having a sell discipline centered around dividends as signals,

just as much as I love having a buy discipline that centers around dividends as a cause and an effect. That's essentially our philosophy and methodology at the Bonson Group. I hope to kind of conclude all of it that these varying thoughts seem coherent to you, cohesive. I welcome questions if you'd like us to button it up more. You know, I'm speaking to an awful lot of people right now that are not clients of Bonson Group and say, why are you giving away your secret sauce to non-clients? Well, or even, you know, other advisors and things. This is not stuff that can be easily executed.

I don't worry about that. So plenty of people try and all that, and I'm all for it. This is not stuff that can be easily executed. I don't worry about that. So plenty of people try and all that, and I'm all for it. I'm just saying I have plenty of confidence in our proprietary process that a lot of blood, sweat, tears, trial, error, time, experience, research intensity goes into that I'm not worried about someone else trying to duplicate it. I'm sharing the methodology. That's all. And we will continue doing what we do day by day. For those of you who are clients, we hope this answers any questions you may have had.

And we invite more any time from any of you. Thank you, as always, for listening to the Dividend Cafe podcast. Thank you for watching the video. And where am I next week? I think I'm still here. I'm still in California. So I look forward to coming to you again next week from our beautiful Newport Beach offices. Thanks for listening to The Divot Cafe.

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