Tuesday, December 2, 2008

Dividend Capture Strategy – The illusion of getting something for nothing

Dividend Capture strategies are gaining popularity among speculators who don’t want to be too exposed to market risk, while also being able to pocket the dividends. My reader Ammar Husami asked me about my opinion on the subject. The dividend capture strategy is very different in comparison to my dividend growth strategy. Before we go any further, there are four important dividend dates that investors need to understand well.

Dividend Declaration Date – This is the date on which dividends are declared by the board of directors.

Ex-Dividend Date – The Ex-dividend date is usually two days before the record date. This is the first day that the stock trades without the right to receive a dividend. On this day the price of the stock will be reduced by the amount of the dividend. The reduction comes from the price of the last trade in the previous session. If you purchase a stock on the ex-dividend date, you won’t receive a dividend until it is declared for the next time period. In order to be able to get the dividend, you will have to purchase the stock before the ex-dividend date.

Record Date - Shareholders who are not registered as of this date will not receive the dividend. Registration in most countries is essentially automatic for shares purchased before the ex-dividend date.

Payment Date – This is the date on which the dividends are deposited directly in your investment account or sent in the mail.
The most important date of all is the ex-dividend date. If you purchase a stock one day before the ex-dividend date and sell it on the ex-dividend date, you will be entitled to receive the dividends.

Let’s view an example of this strategy. Below you could find a sample press release from General Electric (GE):

"August 22, 2008 9:15 AM EDT The Board of Directors of General Electric Company (NYSE: GE) authorized a regular quarterly dividend of $0.31 per outstanding share of the Company's common stock. The dividend is payable October 27, 2008 to shareowners of record at the close of business on September 22, 2008. The ex-dividend date is September 18, 2008.GE is a diversified global infrastructure, finance and media company that is built to meet essential world needs."

The declaration date is August 22, as this is when the press release went out. The record date is September 22, while the ex-dividend date is September 18. The dividend was paid on October 27, to all shareholders who owned GE stock at the close of business on September 17, 2008.

The dividend capture strategy claims that if you purchased the stock on the 17th of September and held it until the 18th; you would be eligible to receive the dividend. The problem with this strategy is that it assumes that markets are not efficient. Dividend Capture does seem appealing to investors who believe that they could get something for nothing, which in an efficient market is almost impossible as all news are immediately priced into the stock. In addition to that even if the trader does receive the dividend payment, there is no guarantee that the stock price won’t fall by more than the amount of the dividend declared.

The issue of taxes also comes to mind when determining whether to do the dividend capture or simply enjoy a simple buy and hold dividend strategy. If you simply owned GE shares and received a dividend from them every quarter, then the highest that you would get taxed at is 15%. In order for you to be eligible for the 15% tax on dividends when you do the dividend capture strategy, you have to hold the stock for at least 61 days. Furthermore, if you sell a stock after holding it for less than one year you will pay short-term capital gains taxes which could be up to 35% for the highest income brackets.

If we go back to the example with GE, the stock closed at 23.39 on Sep 17th. If you sold it on the close on Sep 18 at 24.79 you would have not only made a nice gain and be eligible to receive the dividend, but also would have avoided the volatility in the stock price.

The main issue is that traders with a short-term mindset who are trying to take advantage of the capture strategy could be exposing themselves to market fluctuations. This strategy could be profitable during bull markets as stock prices in general increase which would help the speculators in unloading their position at a profit; during bear markets when the volatility is very high, the risk of catching a big wave down is much higher.

As always, do your own research before trying any strategy that promises free lunch. In the meantime, I have selected several stocks to watch during their ex-dividend days in order to see if there’s any advantage that a dividend investor could achieve by knowing about the strategy of capturing dividends. The following stocks will be trading ex-dividend on December 3:

Bank of America, BAC, dividend amount $0.32, dividend yield 9.96%
Kimberly-Clark, KMB, dividend amount $.58, dividend yield 4.22%
Merck, MRK, dividend amount $0.38, dividend yield 6.12%
Mattel, MAT, dividend amount $0.75, dividend yield 5.96%
Pepsi Cola, PEP, dividend amount $0.425, dividend yield 3.17%
Pepsi Bottling , PBG, dividend amount $0.17, dividend yield 4.40%

Full Disclosure: I own shares of KMB, PEP, GE

Relevant Articles:

- My Dividend Growth Plan - Strategy
- Cola Wars - Coke versus Pepsi
- Analysis of General Electric
- Kimberly-Clark (KMB) Dividend Analysis

16 comments:

  1. I didn't know you could sell a stock before the dividend is paid and still receive the dividend. Since I don't plan on using the dividend capture strategy I guess it doesn't matter much. If I do decide to sell a stock though I'll make sure I don't sell right before an ex-dividend date.

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  2. TFM,

    The dividend capture strategy is pure speculating. I am not a fan. Buy and hold dividend investing - that's what I preach.

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  3. Nice article...I just recently purchased GE mainly for the dividend yeild...too good to pass up...Keep up the great work, I will highlight your posts on my blog

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  4. I wonder if any of your readers have ever used the strategy themselves, and if so, what were their experiences?

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  5. Brad,

    I would love to hear from readers. I doubt however that dividend capture could be performed profitably on a consistent basis.

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  6. This strategy (which as you rightly say is pure illusion) always reappears in bear markets. It's almost a buy signal! :)

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  7. Monevator,

    Investors should be focusing on total returns, not just one aspects of a strategy.

    Thanks for stopping by!

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  8. A lot of dismissive comments...

    Think about it hypothetically. For risk-averse buyers, this strategy would capture a total return equal to the dividend yield, with reduced market risk. The reduced market risk involves a trade-off though--the buyer does lose out on potential capital gains.

    For example, you buy Pfizer thinking that the ~8% yield is sufficient return, and you want to lower your market risk but still acheive that absolute return. You buy the stock before the ex-dividend date, and then put in a limit order to sell at a price that breaks even (after commissions). If the price hits in a day, then you get essentially three months without market risk (if it is a quarterly dividend). If the price falls consistently after the ex-dividend date, you hang on until the price returns to your break-even price. That may take years. But, some of the time the price will rise to your limit price. The time spread between your subsequent sale and the next ex-dividend date will be your reward (less market risk).

    Now, you can dispute whether the absolute return should be sought, or whether you are sufficiently compensated for the risk that you are taking. But, the approach does 'make sense'--you're trading potential equity returns for less risk.

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  9. I add the caveat though--this strategy does require that you can find a safe, solid dividend stock yielding your desired absolute return.

    If you sell after the ex-dividend date, and the stock rises, that same stock may not yield the return you desire. If Pfizer doubles, you'll have to find another 8% yield.

    On the other side though, this strategy can yield a very high internal rate of return for your portfolio over certain periods, as the same capital can be used to retrieve the desired yield multiple times in a given quarter (or year, etc).

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  10. I think Chad's final comment is the interesting one. Let's say that you found three or four dividend paying stocks that you like, whose quarterly x-dividend dates are all different. Also say you did it in an IRA or 401k- so the added taxes would not matter. If you could capture four 5% dividends a year with the same $, you would lose the price appreciation, and surely some of the 20% in transaction fees and losses by selling post x-dividend, but you might get a consistent return of 10-15% after expenses.

    It should also be noted that sophisticated investors also use options to hedge the potential price decline. Conceivable you could also use leverage, especially if you hedge the risk.

    It seems possible that in exchange for some serious work you might be able to get a pretty decent and predictable return.

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  11. Markets are NOT EFFICIENT. If that is central to your argument then you are wrong.

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  12. The flip side to my last comment is that if it were easy to grab a risk free %8 return with this strategy wouldn't everyone do all the time instead of risking capital in other investments. From that view it does not pass the smell test..

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  13. Anonymous's post about markets not being efficient is an excellent point. If markets were exactly efficient, then growth investing shouldn't return any more than any other strategy.

    In any case, large markets are generally efficient (although not necessarily always), but the smaller the market, normally the less efficient it gets. Option markets are much smaller than the underlying stock's market.

    So when you pair dividend capturing with covered calls and IRAs to avoid taxes, you start to get a more viable strategy.

    http://www.dividendium.com/PremiumServices_InflatableDividends.aspx

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  14. there are stocks and funds that pay dividends monthly. find 4 that are on different dates in the month and you have a gold mine. I've doubled my investement every 2 years.

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  15. Thank you for your article. I actually have started to use a Dividend Capture Strategy, and so far I have been successful.
    My methodology includes screening stocks for a variety of characteristics, including price, volatility, cash flow, dividend yield, revenue and profit growth, and a number of other attributes. From a complete list of companies that are approaching their ex-dividend dates over a 4 week period, I narrow the list to a few candidates. Basically, I do not buy stocks of companies that are volatile, or that cannot sustain their dividend. I attempt to purchase shares over a 3 week period to secure an average price that I believe is likely to be exceeded shortly after the ex-dividend date passes. Then I sell the shares, and use the money for the next stock(s) on the list. The underlying premise in this strategy is to only buy companies that I would not object to holding if necessary, should the price decline.
    Since I am using this strategy exclusively in my self-directed IRA, the tax consequences are not an issue.
    I have been successful in using this strategy for about 3 months, and purchases / sales have included T, VZ, DD, BMY, BCE, RAI, CINF, and SO.
    DuPont (DD) took about 3 weeks to reach the average purchase price so that I could exit at a profit, but again, this is a stock that I would not mind holding if necessary.

    I recently started a blog on this topic, highlighting the stocks that I am targeting each week as my next candidates. The current list includes T, VZ and BMY which are all approaching ex-dividend dates in early January.

    Here is the link to my blog:
    http://www.dividendharvestinvesting.blogspot.com

    I am open to comments and critique, but for a portion of my IRA, this seems like a decent strategy.

    Ken Hannan
    ken.hannan@gmail.com

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  16. You have not noted the cost of commissions. They will of course
    reduce your profits.

    ReplyDelete

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