How and why I'll sell dividend shares

My quality dividend model portfolio is a rules-based portfolio. That means I select shares to buy based on their ranking in my scoring system. This ensures that every company is judged in a consistent way, using the criteria I've chosen to define my investment strategy.

If I buy shares in accordance with a set of rules, then clearly I need a corresponding set of rules for selling shares. In my experience, this is much harder to get right.

In this week's post, I want to set out my first pass at defining the rules I'll use for selling shares in the quality dividend model portfolio. I expect these rules to evolve over time, but this is how I'm going to start.

Website update: I've now published the full Quality Dividend Model Portfolio.

When will I sell a share?

Not very often! At least, that's my plan. I aim to choose companies that can deliver reliable income and compound growth over many years. If I get it right, then I won't have to trade very often at all.

I hope and expect to hold the majority of shares in the portfolio indefinitely. But sometimes life gets in the way. Things change. Some investments just don't work out the way we hope they will.

From a rules-based investing perspective, I need to have procedures in place to ensure that any sales are managed consistently and in accordance with my investing criteria. To do this, I need:

• A list of events that will trigger my sale review process
• A clear process for deciding whether to sell

Potential sale events: review process

Although I routinely monitor news and results from the companies in which I'm invested, my default stance is to continue holding unless certain specific trigger events occur:

• Merger/takeover activity
• Dividend cut
• Profit warning
• Significant fall in the stock's quality dividend score

If any of these take place, then I will review the stock to decide whether I should continue to hold it in the model portfolio.

Merger/takeover activity

The portfolio has already had one takeover, which I discussed here. In this scenario there's little choice except whether to sell shares into the market or wait for the deal to complete.

Merger activity is a little different. These combinations aren't always welcome news, in my experience. If a company in my portfolio is entering into a merger, I'll take the following steps:

• Understand the terms of the merger and the expected benefits from combining the two businesses. Are they convincing or compelling, or is this a bailout/takeover in disguise?
• Build a simple financial model to understand what the combined business might look like. For this I'll use similar measures of valuation and quality to those I use in my screening system.

Decision: If I have a strong negative view on the merger, I may sell immediately. Otherwise, I will continue to hold the shares until the combined business publishes its first full set of accounts. I'll then add this data to my screening system to see how the enlarged business scores.

If the stock's financial metrics and dividend quality score remain attractive post-merger, I'll continue to hold. If not, I'll sell.

Dividend cut

One of the main aims of my quality dividend screening system is to weed out companies with unsustainable dividends. I'd hope that dividend cuts will be a rare event, but I can't rule them out.

If a portfolio stock announces a dividend cut, I'll take two steps before making a decision:

• Understand why the dividend is being cut; is the cut a short-term measure for a specific reason, such as a factory fire or natural disaster? Or is the company permanently resetting its payout at a lower level to help address financial weakness, overdistribution, or underinvestment?
• Look ahead; does the reduced dividend remain attractive, based on my criteria for yield, growth and quality?

Decision: If a dividend cut takes place due to a short-term setback, I will normally continue holding the stock as long as my view of the underlying business is unchanged. I may also continue holding the stock if I feel the dividend cut actually improves the quality of the business. Shell's dividend cut (disc: no position) in 2020 is an example of this rare event.

However, in the majority of cases I expect that a dividend cut will be a sign of underlying problems. In this case I'm likely to sell the stock from the model portfolio. In such cases I'll also aim to carry out a more in-depth review to see if I can improve my system to avoid similar problems in the future.

Profit warning

Profit warnings often go hand-in-hand with dividend cuts. Most of the comments above will also apply in the event of a profit warning.

• My first task will be to understand the cause of the warning. Is it a short-term problem caused by an unpredictable event? Or does it reflect on underlying problems with the business, its management or its operating model?

Decision: As a long-term investor, I recognise that problems happen. A profit warning isn't automatically a sell for me, but I'm also conscious of the adage that profit warnings come in threes. So I'll take a critical look at the background to the warning, its cause and the likely outlook.

If I think the problems are solvable, I will continue to hold the stock until a fresh set of accounts are published. I'll then update my screening score for the stock and follow the process outlined below.

Significant fall in dividend quality score

When I add a share to the quality dividend model portfolio, its score in my screening system is a key factor in the decision. So what should I do if this score falls?

A few thoughts:

• Many of the metrics used in the screening rules are unlikely to change quickly. In a number of cases I use five-year averages to smooth out short-term volatility and identify underlying trends. Even on a one-year view, measures such as ROCE or dividend growth rates will not change quickly, because they aren't linked to share price action.
• As a result, I expect the scores for individual stocks to change slowly. So far that's been true.
• I won't be whipsawed into rapid trading decisions simply because of a change in a stock's score. But there may come a time when a company in the portfolio is comprehensively outranked by another comparable business. If this happens, I may have to replace the holding to stay within my rules-based system.
• Regardless of scoring changes, I won't take any action without understanding why a stock's score has changed – both absolutely, and relative to its peers.

Decision: My intention is that I will dampen and slow any trading activity in the portfolio by limiting the frequency with which I allow changes. My plan is to review the portfolio quarterly for stocks whose declining scores might indicate a need for action.

However, my intention – provisionally – is to restrict myself to two trades per quarter. This will force me to prioritise my concerns and limit portfolio churn.

Conclusions

I'll write more about these topics when potential sale situations arise and as my understanding of my system evolves.

I will also explore my process for selecting a replacement stock in more depth in the coming weeks. I'll soon need a replacement for Air Partner (disc: I hold), so this should provide a useful case study.

For now, my guiding principles are that I will not sell a stock without understanding why the situation has changed. I will be prepared to ride out short-term periods of underperformance, if I think the long-term investment case remains attractive.

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I'll be adding a comment facility to this site as soon as I'm able to; I look forward to your feedback over the coming months. In the meantime, you can always reach me on Twitter @rolandhead or by email.

Disclaimer: This is a personal blog. The information provided is for information and interest. Nothing I say should be construed as investing advice or recommendations. The investing approach I discuss relates to the system I use to manage my personal portfolio. It is not intended to be suitable for anyone else.

You should carry out your own research and make your own investing decisions. Investors who are not able to do this should seek qualified financial advice. Reasonable efforts are made to ensure that information provided is correct at the time of publication, but no guarantee is implied or provided. Information can change at any time and past articles are not updated.