Dividend stock investing offers numerous advantages—it can help protect your principal and boost your income. Well-managed, growing companies generate cash flows that can be distributed to shareholders, but their stock prices do not always rise. This raises an important question: “When should you sell your dividend stocks?”
Some investors become so devoted to dividend stocks that they never sell, viewing periodic volatility and even occasional dividend cuts as merely part of the market’s ups and downs. However, for income-focused investors, determining the optimal time to sell can be particularly challenging. Will a decline in a stock’s value recover quickly? Even if dividends are cut, does the stock still have long-term upside potential?
As Jim Cramer famously said, “Paper profits are not the same as money in the bank.”
Below are five useful warning signals that can help you establish an exit strategy and make rational sell decisions to protect your assets.
Warning Signal #1: Deteriorating Cash Flow
When assessing whether a company can sustain its dividend, the first thing to examine is its cash position. Both the cash on the balance sheet and its ability to generate cash flow are critical. If a company’s cash flow deteriorates or it accumulates an enormous amount of debt, its ability to pay dividends will likewise weaken.
Warning Signal #2: Declining Credit Ratings
This signal was particularly evident among energy companies in 2016. Renowned energy stocks such as Chevron Corp. (CVX) and Mobil Corp. (XOM) saw their credit ratings downgraded by agencies like Moody’s. Generally, a decline in credit ratings forewarns of an impending formal downgrade, which indicates higher borrowing costs when issuing new debt. Consequently, companies often resort to significant dividend cuts to preserve cash flow and protect their credit ratings.
Warning Signal #3: Weak Fundamental Metrics
Earnings seasons reveal which companies can sustain share repurchase programs and dividend payments. Companies with weak fundamentals—unable to boost cash flow through revenue or earnings growth—must find ways to bridge the gap and secure cash. Typically, the first step is to halt share repurchase programs, followed by cutting dividends if necessary.
Warning Signal #4: Suspension of Share Repurchase Programs
As of July 2020, a low interest rate environment spurred an aggressive wave of share repurchases, as companies issued low-cost bonds to fund buybacks, thereby reducing the number of shares outstanding and boosting the value of the remaining stock. However, when a company scales back or stops its repurchase program, it can be a red flag—often indicating that it either lacks sufficient cash to support the program or has taken on too much debt. Without enough cash to continue repurchases, dividends may become the next target for cuts.
Warning Signal #5: Falling Stock Prices and Rising Dividend Yields
When a company faces financial stress, it may resort to unsustainable measures to maintain its dividend. For instance, it might cut costs or divert funds originally earmarked for capital expenditures to pay dividends, or it might increase debt or sell shares to secure additional funding for dividend payments. The interesting aspect is that when these measures occur, the dividend yield may appear more attractive to income-hungry investors simply because the stock price has fallen. However, if investors fail to examine the underlying reasons for the rising yield, the company may ultimately be unable to sustain the dividend, leading to severe consequences when a cut eventually occurs.
