Selling Overvalued Position

[KenBob]

I have a rule that when a position becomes excessively overvalued, that the position will be rebalanced. Note that I don't rebalance due to a position being overweight.

The key was defining what is excessive. After much consideration, I decided a position is excessively overvalued when investing in another stock at fair value will result in more dividend income after capital gains taxes than staying in the original stock.

The actual point where a stock would be considered overvalued will depend upon the characteristics of the original stock and the replacement stock; however, I was interested in a rule-of-thumb, so some simplifying assumptions were made. First, the yield of stocks at fair value are similar and the yield varies inversely proportional to the ratio of the current price over fair value. Second, the error due to using the total value of the current stock for taxes is of the same magnitude and offset by the error in calculating fair value. With these assumptions, the following relationship was derived for the breakeven point:

Overvalue Price/Fair Value Price = 1/(1 - Tax Rate)

For long term, Pov/Pfv = 1.18
For short term, Pov/Pfv = 1.33

Assuming stocks are bought at fair value or lower, this results in selling due to overvalue being relatively rare.

[DividendDragon]

(10-04-2015, 10:34 AM)KenBob Wrote: I have a rule that when a position becomes excessively overvalued, that the position will be rebalanced. Note that I don't rebalance due to a position being overweight.

The key was defining what is excessive. After much consideration, I decided a position is excessively overvalued when investing in another stock at fair value will result in more dividend income after capital gains taxes than staying in the original stock.

The actual point where a stock would be considered overvalued will depend upon the characteristics of the original stock and the replacement stock; however, I was interested in a rule-of-thumb, so some simplifying assumptions were made. First, the yield of stocks at fair value are similar and the yield varies inversely proportional to the ratio of the current price over fair value. Second, the error due to using the total value of the current stock for taxes is of the same magnitude and offset by the error in calculating fair value. With these assumptions, the following relationship was derived for the breakeven point:

Overvalue Price/Fair Value Price = 1/(1 - Tax Rate)

For long term, Pov/Pfv = 1.18
For short term, Pov/Pfv = 1.33

Assuming stocks are bought at fair value or lower, this results in selling due to overvalue being relatively rare.

I don't sell positions unless the dividend is cut or if there is a rapid deterioration in future prospects.

I wish I was in a position to rebalance but in the UK the average brokerage fee is around $18 so it's very expensive to do so.

DD

[Dividendsrule]

For a person who needs to live off of his dividends in the next decade or so, I could see taking the gifts that the market Gods give you, and sell one stock one perceives as overvalued, and reinvest into another higher yielding stock, like a REIT or something like that. Especially if it's in an IRA, not getting taxed on the capital gain, and not getting extra taxation on a REIT's ordinary income dividends.

However, as a younger guy with time to really let the portfolio compound, I don't generally sell my DGI stocks at all. There was a period of time where I was extremely tempted and it was really wracking me. But I processed the emotions and decided against it. At the time one of my stocks had appreciated 100% in a few years, now it has appreciated 300% and I still won't sell.

The reason I decided against selling is primarily to keep the diversification in my portfolio. As Peter Lynch was quoted to have said, diversification is your only free lunch.

I appreciate that your formulas and conclusion led you to say that it would be rare to sell an overvalued stock, Kenbob. What I tell people is, "reductio ad absurdum" (to reduce it to absurdity), if I were to get into the practice of selling lower yielding stock for higher yield, my entire portfolio would turn into MO (and now PM). lol

DividendDragon, it appears to me that Interactive Brokers in the UK charges 6 pounds per trade in the fixed commission structure.

[KenBob]

If a stock is truly overvalued, it should revert to fair value eventually. The real question I was trying to answer was at what level of overvalue does it make sense to take advantage of the excess capital the market is offering. My conclusion was that I don't want to sacrifice income due to capital gain taxes. The formula was derived as a rule-of-thumb for the breakeven point.

My basic assumption is that yield for good dividend growth stocks tend to be in a narrow range and the yield of an overvalued stock is reduced, since it is overvalued. It is this difference in yield that is used to compensate for taxes. Many stocks should be available at fair value, so it is not necessary to chase higher yielding stocks.

[cannew]

Nothing wrong with your reasoning and as you say stocks will normally revert to mean.

However, having said that I hold for the rising income and if stocks are over-valued and continue to rise, so likely is the dividend. I am retired and mostly ignore market value. Agree with Dividendsrule, as long as the dividend is safe.

[Kerim]

This is a great topic, and for me comes down to a question of style purity.

What you are describing, I think, is layering some value investing principles on top of your base dividend growth approach. I think the idea has merit, though I have not been brave enough to wade into those waters myself. Pure value investors buy low, wait for the price to revert to fair value or better, then sell. Rinse and repeat.

To me, strict dividend growth investors don't generally adopt this practice. They are focused on income and the safety / growth of the dividend stream. Their sell criteria are tied to those metrics and not to valuation. (And this is NOT undermined by the fact that their buy criteria is often very focused on valuation.)

I've often said that the first approach, the value approach, is far more likely to make you rich while you are young enough to enjoy it -- but only if you can do it right. But in my opinion, it is much harder to get right that a more pure dividend growth approach. I personally do not have the time or skill to make that strategy work. I do (I think!) have the time and skill to make a dividend growth strategy work.

I've often been tempted to try and combine the two approaches in a way similar to what you are describing. Stick mostly with a pure DG strategy, but be open to selling when one of my holdings appears truly overvalued and I could replace it with another DG stock of high quality and low valuation. I've been eyeballing WBA lately with these thoughts in mind. I've got a nice double on the price, and could replace the 1.7 percent yield with something much higher (EMR, PH, or even JNJ). But is WBA excessively overvalued? I don't think so. With earnings increasing after the merger, we could be looking forward to some solid dividend growth. So I'll probably just sit tight.

KenBob -- would you be willing to share some specific examples of trades you've made or contemplated along these lines?

[KenBob]

I don't sell overvalued positions very often myself, but it seems a pity to waste an opportunity when presented.

A couple of years ago, I sold WAB after it rose quickly in value; however, that was not based on the rule-of-thumb.

What I am monitoring now is SYY, which is in my wife's portfolio. I assume a forward PE of 16.05 as fair value (the average forward PE for the SP500), while my rule-of-thumb results in a forward PE of 18.88 for rebalancing. Just looking at SYY, the forward PE is now 18.95, so I will probably rebalance this position.

Since WBA has a forward PE of 18.56 (Yahoo Finance), my rule-of-thumb would state that WAB is getting close, but has yet to reach the breakeven point where income would not be sacrificed by rebalancing.

[KenBob]

My previous comments were based upon a taxable account.

For an IRA, any additional funds would be taxed as ordinary income upon distribution; therefore, the overvalue price over fair value price ratio would need to be 1.33 if there was no compounding in interest.

However, there is a time delay between the acquisition of the extra capital and the tax, so compounding should occur.

My head is aching over trying to make that calculation, so I plan to use the more conservative ratio of 1.33 for my IRA.

[Dividend Watcher]

I have several guidelines in my business plan that directly address selling on overvaluation: (1) consider selling a portion of the investment when it becomes over 8% of the portfolio or (2) the P/E (excluding extraordinary charges) exceeds 24, and (3) strongly consider selling the entire position when it becomes seriously overvalued. This includes a P/E ratio greater than 30 or greater than 200% of the average P/E for the trailing 10 years.

The goal here is to take the profits on something that is priced by "irrational exuberance" rather than fundamentals and to prevent one or two stock(s) from dominating the portfolio. Since our retirement accounts will be needed to supplement our income, I don't want to jeopardize the income stream should a problem arise. Of course, there are some caveats here. One is the admonition to try and have something more reasonably priced to replace it. The other is for those companies that are in the "special situations" category. Unspoken is the goal of minimizing transaction costs and being whipsawed in/out of a position by short-term circumstances.

I'm less tolerant of overvaluation of utilities rather than other C corps only because of the slow growth nature of the business. C corporations also have the luxury of being more flexible in how they make their money.

All that to say that I have sold partial or the entire positions for overvaluation before and would do it again in the right circumstances. KenBob, what surprises me is your willingness to trade more in a taxable account rather than in a retirement vehicle. I guess if your formula gives you enough margin to make it worthwhile to book the profit, then it makes sense to trade when you feel necessary.

[benjamen]

I generally ignore stock prices once I purchase a stock. I do look to avoid any one stock contributing more than ten percent of my overall yearly dividend stream.