Tuesday, April 24, 2012

Things You Need to Know about Selling Stocks

In the spirit of My Own Advisor’s post The Top 5 Things You Need to Know about Dividend Paying Stocks, I decided to sing the merits of selling 5% of your stocks each year.  I don't want to pick on My Own Advisor because he's a good guy and many blogs say similar things, but I had to pick some blog to have some fun with.

1. Selling 5% of your stocks each year provides an immediate return.

Even if your stocks subsequently go down in value, you get to keep the cash from selling 5% of your stocks each year.

2. Safety buffer against the worst case scenario.

If the worst happens and the businesses you own go bankrupt, you get to keep the cash from 5% sales in all previous years.

3. The value of that 5% increases over time.

As long as your business is successful and produces more than a 5% yearly increase in share value, each year’s sale will be worth more than it was the previous year.

4. Many businesses have a long history of rising share values.

Several Canadian banks along with BCE have been around since the nineteenth century, and their share values have risen impressively.

I won’t torture you with an attempt to match the fifth point. The main idea is that if a business doesn’t give some of its cash back to shareholders in the form of a dividend, you can always just sell some of the stock. Only a fraction of the sale will be taxable as a capital gain, making this approach more tax-efficient than dividends. I’m not saying that dividend investing is necessarily bad, but many of the trumpeted benefits exist more in our minds than in reality.

24 comments:

  1. Love this.

    p.s. I think your link to MOA is incorrect.

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  2. @Mike. Thanks. It's fixed now. I suspect you're one of the few who will love this, but it's all in good fun.

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  3. Oh no! Now you've made the dividend hornets mad :)

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  4. Ha Ha, I think this was written as a joke ;) If I acually took this post seriously, or actually believed what you are writing here - I would have increased my blood pressure. LMAO

    So just in case you are actually serious (you never know), do you plan to skim off 5% of your ETFs distributions each year and deplete your overall capital growth as well? Or is this a special strategy that is just reserved for dividend investors - so they can forgoe all their hard work with DRIPs?

    Cheers ;)

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  5. @Dividend Ninja: My claim is that if there are two well-run businesses with similar economics where one pays a 5% dividend and the second doesn't, investors in the second business can just sell 5% of their shares each year if they want an income stream. These sales will have a similar effect on capital growth as the paymnet of a dividend has on the first business.

    I'm afraid that I didn't follow your comment about DRIP investors.

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  6. I honestly did not think you were serious. This doesn't make any logical sense to me at all - I really don't understand the premise of your article.

    Why would you keep skimming off your profits each year,and slightly depleting your capital each year, instead of letting your investment build and grow - and allowing compound growth to do its work? Would you deplete 5% of your ETF portfolio every year? If not why not?

    With DRIPs I meant by taking off 5% every year, you wouldn't be able to reinvest your dividends (or with ETFs reinvesting your distributions) to take advantage of compound growth.

    Like I said, I really didn't think you were serious when you wrote this article - becuase I took the entire post as a joke. LOL

    Cheers

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  7. @Dividend Ninja: I was looking at the case of a dividend investor who uses a 5% dividend for income to live on (rather than for reinvestment). For an investor who is at a stage in his or her life where there is no need to draw an income, the comparison is different. In this case, the investor should have no preference between the two choices in a tax-advantaged account, and should prefer the business that pays no dividend in a taxable account.

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  8. @Dividend Ninja: I chose 5% because that's what My Own Advisor used as an example. And 5% would be perfectly sustainable for an 80-year old.

    You seem to believe that dividends come for free and don't affect capital growth of stocks. This is not true. If I own dividend stocks that pay a 5% dividend (and I live on this income), I'm no better off than if I own stocks that pay only a 2% dividend and I sell 3% of my holdings each year. In fact, I'm slightly better off in the latter case due to greater tax efficiency.

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  9. Thanks Michael, I'm not 80 years old yet, and plan to enjoy my portoflio income before I am 80 - therefore I will live off the income it generates. ;)

    I'm sorry Michael, in all honestly I have no idea what you are talking about, or what the purpose of this article was - and your comments do not make any sense.

    Oh well, time to get some real work done now.

    Cheers

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  10. There's no reason this strategy couldn't be turned into a DRIP. Just take the 5% annual withdrawal and buy some more shares. ;)

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  11. @Mike: ... and it will only cost $20 in commissions! :-)

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  12. Hi Michael,

    I'm with Dividend Ninja, I thought this was a joke or you were just being sarcastic.

    Let's take a look at the comparison more closely. Using the Ernst & Young Tax Calculator for 2011 (http://www.ey.com/CA/en/Services/Tax/Tax-Calculators-2011-Personal-Tax) someone earning $75,000/yr in BC would pay the following tax rates:

    - marginal rate on capital gains 16.25%
    - marginal rate on CDN dividends 8.11%

    On a $400,000 portfolio selling 5% of your stock ($20,000) will cost you $3250 in taxes.
    The tax on 5% dividends ($20,000) will cost you $1622.

    Using the same calculator but using $20,000/yr as your sole income shows the following taxes rates for someone in BC:

    - marginal rate on capital gains 11.63%
    - marginal rate on CDN dividends 0%

    In fact you could earn $41,000/yr in CDN dividends tax free. The same $41,000/yr in capital gains would cost you $4653.50 in taxes.

    You mentioned "The main idea is that if a business doesn’t give some of its cash back to shareholders in the form of a dividend, you can always just sell some of the stock." but this only works if the stock price continues to go up every year. It won't work if the stock price goes down, this is where the dividends will come in handy. Here's an example using Walmart:

    WMT stock price:
    2004 $60.24
    2005 $49.90
    2006 $49.20
    2007 $48.06
    2008 $56.29
    2009 $47.79

    Even though the stock price went down in 6 years, the dividends continued to increase every year.

    2004 $0.48
    2005 $0.58
    2006 $0.65
    2007 $0.83
    2008 $0.93
    2009 $1.06

    CC warned you about the hornets :)

    cheers,
    Kanwal

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  13. @Kanwal - but you're assuming an ACB of zero.

    and re:

    "You mentioned "The main idea is that if a business doesn’t give some of its cash back to shareholders in the form of a dividend, you can always just sell some of the stock." but this only works if the stock price continues to go up every year. It won't work if the stock price goes down, this is where the dividends will come in handy"

    I doubt dividends could continue to be paid if the share price of a dividend paying stock only went down.

    I think what Michael is alluding to is that retained earnings are normally paid out as dividends if a company (or shareholders) feel that they can no longer re-invest the retained earnings in the company and achieve greater growth than the shareholders could by deploying that capital elsewhere. Therefore with two similar businesses, whether the retained earning are reinvested or paid out as dividends has no pre-tax difference. The post-tax difference will vary according to the individual investor.

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  14. @WhereDoesAllMyMoneyGo.com Agreed no pre-tax difference.

    "I doubt dividends could continue to be paid if the share price of a dividend paying stock only went down." I used to believe that until the last 14 years taught me otherwise. Allow me to clarify and then provide some proof.

    It sounds ridiculous but companies have continued to increase dividends even when their stock has remained flat long periods of time.

    Stock prices fluctuate for many reasons, one of the reasons is investor sentiment. Investors get emotional and that causes prices to drop or remain flat. On the other hand dividends are paid out of earnings. As long as the earnings are increasing, there is a good chance dividends will continue to increase.

    2003 CAH stock price $40, dividend $0.11
    2012 CAH stock price $40, dividend $0.86

    2004 OMC stock price $45, dividend $0.40
    2012 OMC stock price $49, dividend $1.20

    2002 ABT stock price $58, dividend $0.92
    2012 ABT stock price $59, dividend $2.40

    2004 AFL stock price $42, dividend $0.38
    2012 AFL stock price $42, dividend $1.32

    2001 AVP stock price $20, dividend $0.40
    2012 AVP stock price $20, dividend $0.92

    I would love to have my stocks increase in price as the dividends are increased and most times this does happen. I just wanted show that in some cases the stocks prices remain flat while the dividend continues to increase each year.

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  15. Michael, please delete this post: you might discourage dividend investors. Most stocks don't pay dividends. All these dividend investors are helping to drive down the price of nondividend paying stocks, which increases the returns of those of us who focus on total return.

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  16. @Kanwal - "It sounds ridiculous but companies have continued to increase dividends even when their stock has remained flat long periods of time."

    That doesn't sound ridiculous, but what I said was that I doubt dividends could continue to be paid if the share price of a dividend paying stock only went down.

    You said:

    "You mentioned "The main idea is that if a business doesn’t give some of its cash back to shareholders in the form of a dividend, you can always just sell some of the stock." but this only works if the stock price continues to go up every year. It won't work if the stock price goes down, this is where the dividends will come in handy."

    A stock would not need to go up every year in order to sell stock every year and still have a gain. For the same reason as pointed out in your examples of companies that increased dividends while share prices after a long period of time were lower than initially. By adjusting the term you and Michael could both provide support for your positions.

    "As long as the earnings are increasing, there is a good chance dividends will continue to increase."

    Similarly, as long as the earnings are increasing, there is a good chance share price would increase or rebound if down.

    I don't want to make it sound like I'm anti dividend investing, I'm just trying to elucidate my understanding of Michael's position as what he said makes sense to me.

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  17. For the 5th point, buying based on dividend yield is no more (and no less) valid than buying based on P/E.

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  18. @Kanwal and @Preet: Preet is right that Kanwal failed to account for the ACB and the benefits of tax deferral that come with capital gains. At their core, many of the arguments put forth by dividend investors only make sense if one accepts that dividend paying stocks tend to have higher overall returns than non-dividend paying stocks. I don't believe this will be true over the long run.

    @Anonymous: Good one :-) I'd be happy to have depressed stock prices for a few years.

    @Patrick: That's probably better than what I would have come up with.

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  19. Nice :)

    I did like this: "...if a business doesn’t give some of its cash back to shareholders in the form of a dividend, you can always just sell some of the stock.”

    All in good fun Michael.

    @CC, the hornets have been released for some time, you just gave us some nectar to nibble on... :)

    That said, I might have to index more, TransAlta is killing me right now.

    Mark

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  20. Michael, this is all very good, but I like Fortis.

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  21. @Michael James - you said, "many of the arguments put forth by dividend investors only make sense if one accepts that dividend paying stocks tend to have higher overall returns than non-dividend paying stocks. I don't believe this will be true over the long run."

    This seems to true, historically. Why don't you believe this will be true over the long run?

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  22. @Mark: Be careful of shifting to indexing. It's seductive. You might never want to look at a balance sheet or income statement again.

    @Dan: You have me conditioned now. Every time I see Fortis in the news I start to laugh :-)

    @Echo: The evidence I've seen is that dividend stocks have performed the same as other value stocks over the long run. What historical evidence are you referring to?

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  23. 5% of your portfolio varies greatly year to year. One year a portfolio could be one million and your example would be $50,000 which would be a great income. But the next year with a reasonable decline of say 10 percent, the 5% you sell would $42,750. If this person were living off selling their shares then that year could be a lot less fun than the year before.

    When the stocks you hold are down that is the best time to buy, but if you require that money to live off then you are selling at the worst time and can't take advantage of the deflated price.

    Dividend investors tend to invest in companies that increase payouts, so they are less likely to suffer a year where they have lower income from their investments like someone who has to sell their investments. If I buy a stock with a 5% yield, that dividend may go up and a $1000 original investment that paid $50 will pay $70 or more in ten years, even if the stock price remains flat or decreases even.

    Lots of people do the method you advocate, hence the rule of thumb that you can sell 4% of your portfolio each year without decreasing capital too much. To each his own. I do not disagree with you necessarily, just offering the flip side of the coin.

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  24. @Poor Student: At its core, your argument amounts to an expectation that dividend stocks will have higher total returns over the long run than other stocks. If this proves to be true, then your reasoning will hold up. If this proves to be false, then dividend investors will not enjoy the advantages over other investors that you describe.

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