We’ve compared managing investment portfolios to caring for a garden. To maintain overall health, one must occasionally prune, weed and even transplant. We typically “prune” individual stocks that have enjoyed a period of strong relative performance in the market. Doing so not only forces us to take some profits along the way, but also frees up some cash for future deployment, either in new ideas or existing holdings that haven’t done as well. It is hard to buy low, after all, if you don’t have any cash to do so! The process also helps us to be more intentional in understanding the risk and return trade offs we’re taking with our portfolio, rather than allowing the portfolio’s performance itself to assume that role.
When we trim or prune a name, we create a capital gain, taxed at the 15% rate. When a company declares a dividend, on the other hand, the distribution is taxed at normal income tax rates, which for most folks are higher. In addition to paying a lower potential rate on a return of capital, we also control the timing of any payment by using this approach. And perhaps most importantly, the discipline forces us to think more like the CFO. We are forced to be more intentional about each investment we’re making, deciding whether or not it makes sense at any moment in time to keep cash in the business for the future or to remove it for a new opportunity.
Got Dividend? Always. If you want one, make one!