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When to Sell a Dividend Stock: Key Warning Signs

Dividend growth investing relies on holding stocks with consistent dividend payouts, strong dividend growth, and attractive yields. This strategy benefits from the double compounding effect, where both dividend reinvestment and stock price appreciation enhance returns. However, when a stock no longer aligns with these principles, it may be time to sell.

Here are seven major warning signs that indicate when to consider selling a dividend stock.

Lack of Dividend Increases

One of the primary reasons to sell a dividend stock is a failure to increase its dividend. If a company has gone a year or two without raising its payout—assuming no significant economic downturn—this could be a red flag. Dividend investors rely on both yield and growth to maximize compounding, and stagnant dividends suggest underlying financial struggles. Often, companies that fail to increase their dividends are burdened with excessive debt or cash flow problems, potentially leading to future cuts or suspensions.

For example, Johnson & Johnson (JNJ) has demonstrated a strong history of annual dividend growth for over 57 years. In contrast, Abercrombie & Fitch Co. (ANF) has paid dividends since 2004 but has not increased its payout since early 2013. Investors holding ANF for dividends should consider selling.

Dividend Cuts or Suspensions

If a company cuts or suspends its dividend, it fundamentally disrupts the dividend growth strategy. Without dividend payments, compounding ceases, diminishing long-term returns. In most cases, once a company cuts its dividend, it may do so again in the future, signaling financial instability.

A prime example is Citigroup (C), which suspended its dividend during the 2008-2009 financial crisis and did not resume significant payouts until 2015. Investors who relied on its dividend should have exited their positions after the initial cut.

Drastic Changes in Dividend Payout Ratio

The dividend payout ratio measures the proportion of earnings paid out as dividends. Sudden increases or decreases—typically of 10% or more—can be a cause for concern. A sharp rise may indicate that a company is distributing dividends unsustainably, while a significant drop could mean reinvestment priorities have shifted away from dividends.

For instance, Western Digital Corporation (WDC) has exhibited sharp fluctuations in its payout ratio, often exceeding the ideal threshold of 50%. Such volatility raises doubts about the sustainability of its dividend payments.

Credit Rating Downgrades

Credit ratings reflect a company's financial stability and ability to manage debt. A downgrade by agencies like Moody’s, Standard & Poor’s, or Fitch suggests a weakening financial position. Companies with lower credit ratings may face higher borrowing costs, leading to dividend cuts or suspensions to conserve cash.

In April 2020, Moody’s downgraded Exxon Mobil Corporation (XOM) to an Aa1 rating. Although still relatively high, such a downgrade warrants further investigation into the company's financial health before continuing to hold its stock for dividends.

Elimination of Stock Buybacks

Stock buybacks indicate financial strength, as they reduce outstanding shares and increase earnings per share. When a company suspends its buyback program, it may be conserving cash due to rising debt or declining revenue. This often precedes dividend reductions.

Tracking stock buybacks requires monitoring quarterly financial statements to see if the number of outstanding shares is shrinking. A sudden halt in buybacks could signal trouble for dividend sustainability.

Falling Stock Price with an Unusually High Dividend Yield

A dividend yield above 7% is often a warning sign rather than an opportunity. Known as a “yield trap,” such high yields usually result from a declining stock price rather than healthy dividend growth. Companies in this situation may struggle with revenue declines, debt accumulation, or poor cash management, making dividend cuts likely.

The dividend yield formula—Annual Dividend Per Share / Stock Price—illustrates how a falling stock price can artificially inflate the yield. Investors should analyze the reasons behind a stock's decline before assuming the high yield is sustainable.

Drastic Stock Price Increases

Sudden spikes in a stock’s price—such as gains of 10% or more within a few days—may present an opportunity to take profits. While dividend investors typically focus on long-term holding, selling a portion (e.g., 15%) of an overvalued stock can lock in gains without sacrificing the entire dividend stream.

For example, Coca-Cola (KO) has experienced short-term price fluctuations that could be leveraged for profit-taking. Selling into strength and reinvesting in attractively priced dividend stocks can optimize portfolio performance.

Evaluating the Dividend Coverage Ratio

The dividend coverage ratio assesses a company’s ability to maintain its dividend payments. It is calculated as:

Dividend Coverage Ratio = Earnings Per Share (EPS) / Annual Dividend Per Share

A ratio below 1 signals that the company is paying more in dividends than it earns, which is unsustainable. A ratio above 1.5 generally indicates a safe and stable dividend.

McDonald’s Corporation (MCD), for example, had a dividend coverage ratio of 1.576 in 2019, suggesting that its dividend was well-supported by earnings.

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Nothing in this newsletter is financial advice. Always do your own research and think for yourself.