During the last monthly review for my Dividend Growth Portfolio, I noted that McDonald’s (MCD) had expanded to occupy >12% of the portfolio.

This happened because MCD has been on an upward price tear. That has caused its dividend yield to fall.

The business plan for the portfolio has guidelines about selling or trimming positions:

McDonald’s checks 3 of those boxes:

• Position size > 10%
• Yield has dropped below 2.5%
• Seriously overvalued

Note MCD’s valuation on the following chart.

In the past 2 years, McDonald’s valuation has levitated beyond historical norms for both the market (orange line) and McDonald’s own historical valuation (blue line). That’s why, despite increasing its dividend every year, MCD’s current yield has dropped to 2.4%.

So I decided to trim the position and put the money to work elsewhere. Here’s what I did.

Trimming McDonald’s

First, I determined to sell about $3300 worth of McDonald’s. That would take its position in the portfolio back to about 9%. Here’s the sell order that was executed on November 1. I sold 20 shares.

Proceeds from the sale (after commission) were $3335.

Deciding What to Buy

Next I spent a couple of hours researching what to replace the McDonald’s shares with. When I trim a stock, I don’t hold onto the cash.

The main goal of the portfolio is to produce reliable growing income, and cash doesn’t advance that goal.

In a nutshell, what I did was examine the last 12 months of Dividend Growth Stocks of the Month plus look at possible candidates from among stocks already in the portfolio.

I looked at yields, Dividend Safety scores from Simply Safe Dividends, ex-dividend dates (so as not to miss a Q4 payment), company quality, and valuation.

In the end, I decided to split the money and add 1 new stock plus increase the holdings of 1existing stock.

The new stock is Smucker (SJM), which was the Dividend Growth Stock of the Month for October, 2017 (see this article for a full analysis).

I like Smucker’s dividend record, safety, yield (3.0%), and defensive industry (consumer staples), among other things. Its next ex-dividend date is November 9, so I won’t miss their final dividend payment of the year.

Beyond the quality of the company and its dividend record, Smucker’s valuation has improved considerably in the past year. Its price has dropped not only below its own historical valuation but also below the market’s historical valuation.

Therefore, with about half the money, I bought 15 shares of SJM. This is a new stock for me, bringing the number of stocks in the portfolio to 22. Here is the order summary from E-Trade.

The cost of that purchase, including commission, was $1592.

With the rest of the money, I decided to add to my existing position in Realty Income (O). This iconic REIT has been selling off over the last year. While that has not brought it into undervalued territory, I calculated that it is just 8% overvalued, which I am willing to pay for a company of such high quality. (I usually consider any price within 10% of my fair value estimate to be “fair” for a high-quality company.)

O was already in the portfolio, having been purchased twice in 2008. As you can see, since then it has spent most of its time significantly overvalued, which is why I had never added to the position since then. O pays monthly and is yielding 4.7%.

Here’s the order summary. Total cost for 31 shares was $1676.

So altogether I spent $3268 of the $3335 realized from the sale of MCD. I left the $67 extra dollars in the portfolio’s cash bucket, where it is building up to the next $1000 threshold for reinvesting dividends. That will happen next month.

How Will These Trades Affect the Portfolio?

I accomplished several goals with these 3 trades.

First, I reduced the risk of the portfolio. My 10% max-size guideline is already far above what most investors would tolerate. Many investors won’t go above 3% or 5%. I’m more flexible, but I have my limits too.

Adding a new stock bring the total to 22, which also tugs down risk a little. It is said that diversification is the only free lunch in investing. The addition of consumer-staple Smucker broadens the portfolio’s diversification by a smidgen.

Second, I increased the yield of the portfolio. Here is the before-and-after income picture on an annual basis:

Before:

After:

[Source: Simply Safe Dividends Portfolio Analyzer]

By making the adjustments, I immediately added $45 per year to the expected income from the portfolio. That doesn’t sound like much, but it is more than a 1% increase. When you are building an income wall, every brick helps.

The current yield of the portfolio went from 3.5% to 3.6%.

Yield on cost inched up too, rounding now to 8.1% from 8.0% before the trades.

At 8.1%, it hits a new high.

Third, I complied with the selling guidelines by trimming MCD to 9% of the portfolio from 12%.

After the trades, SJM becomes a new position clocking in at a little over 1% of the portfolio.

O increases from 6% of the portfolio to 8%.

So overall the portfolio is a little more balanced than before.

Fourth, I didn’t damage the portfolio’s dividend resume. Per Simply Safe Dividends, dividend safety remained the same with a score of 81 for the whole portfolio. Price volatility (beta) dropped a tiny bit, from 0.67 to 0.66.

Those are all apparent benefits to this long-term portfolio.

But whenever you make a change, you always give up opportunity costs, because you forfeit what might have happened if you’d just done nothing. With these trades, I give up a portion of MCD, which might continue on its price tear. I add to O and get a new stock, SJM, whose prices have generally been falling and may well continue to fall.

McDonald’s has been increasing its dividend faster than Realty Income, but Smucker has been increasing faster than MCD until this year. It’s difficult to discern whether anything changed overall on the dividend-growth front.

Of course, projecting prices and dividend increases into the future is speculative. The best you can do as an investor is make good decisions based on your goals, strategies, time-frame, data, and solid reasoning. We won’t know the full impact of these trades for years.

I accomplished my main goal, which was to reduce the size of a position that had become bloated. That’s in my business plan, and I carried it out. By having those guidelines in the business plan, I prioritize balance and diversification higher than the principle of “let your winners run.” McDonald’s ran too far for my comfort.

All of the changes will be reflected in the next monthly portfolio update.

Caution: Please don’t take anything in this article as advice to sell McDonald’s or to buy Smucker or Realty Income. Always perform your own due diligence, taking into account your goals and strategies before buying or selling anything.

— Dave Van Knapp

[ad#wyatt-income]