Dividend Stripping by Marcus Padley posted on Feb 14 05:52am
Marcus Padley A guide to getting the most out of dividends.
We are into the results season and it is time to start maximising those relatively huge Australian dividend pay outs (relative to the yield on Bonds and bank accounts). On current forecasts over a third of the top 200 stocks yield more than 6.0% including franking. So there's plenty of value out there.
A lot of you probably know all about dividend stripping and you will all have had a variety of success or otherwise with it. But for those of you without the experience but with enough nous to know you could be maximising the income and franking on offer in the next couple of months then here are a few pointers:
* The basic principle of dividend stripping is to buy a stock before it's Ex dividend date and sell it after it goes Ex. The hope is to pick up the dividend, the imputation credit and a capital gain at the same time....or at least a capital loss which is smaller than the dividend gain (and you use the capital loss to offset gains elsewhere).
* Stocks with big dividend pay-outs often run up in price ahead of the Ex Dividend date. Traditionally the Commonwealth Bank would run a month ahead of its results. The CBA is the only major bank with results and a dividend this season.....so buy early, not the day before.
* In a low interest rate environment the attraction of dividends over interest has led to some reasonably predictable share price rallies in safe income stocks ahead of results.
* Remember the 45 day rule. If you are going to achieve more than $5000 in imputation credits in the tax year then you need to observe the 45 day rule. This says that you need to hold a stock for 45 days not including the buy or sell date to qualify for the franking credit and you must have the risk on the stock for the entire period (can't hedge 100%). So buying 45 days before a stock goes Ex dividend makes sense......this will usually catch the pre dividend run if there is one and will give you the freedom to sell immediately the stock goes Ex should you wish to. (You don't have to buy 45 days before it goes Ex....you can buy 1 day before and hold for the next 45 days if you like).
* The share price drops the day it goes Ex Dividend....usually by the size of the dividend. Most dividend strippers work on the basis that when a stock goes ex a 20c fully franked dividend it usually drops 20c....not 20c plus the franking....so they are hoping to pick up the franking for free.
* In stocks that are not reliable payers but have a big one off dividend, the post dividend fall tends to be more pronounced as the people who "only" bought for the dividend exit again and there are no natural buyers to support the stock. In other words it is hard to strip big dividends out of stocks that don't regularly pay big dividends...because they are not defensive and you get caught in the "sell at all costs, the games over" selling after the dividend goes Ex.
* When the stock drops you also lose 20c of capital....which is a tax saving as well (perverse theory). Dividend stripping is often a swap between income and capital gain. Better if you have a lot of capital gains to offset.
* Overseas shareholders don't get franking credits....so stocks like Qantas with large foreign shareholder bases are often thought to be sold off by international traders ahead of a big dividend and then bought back. This is not a factor in small stocks that are not institutionally held.
* The stocks that are most likely to "carry" their dividends are the big internationally traded stocks....because international funds don't get the franking and often prefer to buy ex the dividend rather than cum. If they buy just before a big fully franked dividend they often end up paying a "premium" built into the share price ahead of an ex date by the domestic investors who do get the franking. In other words you are safer buying banks and big income stocks that international institutions will support after they go Ex than you are crappy little stocks that no one wants to buy after they go Ex.
* Dividend stripping is a lot more profitable in a rising market. In a bear market you are on a hiding to nothing. The current market volatility does not make dividend stripping easy...it is no lay down. In which case the best ploy is to try and strip stocks you wouldn't be too concerned holding on to in the medium term should the market go against you.
* When stocks like the banks go Ex Dividend....there is often quite a switch out of the bank that went Ex and into the next one going Ex. So if you have the cash you would be buying Bank X before Bank Y goes Ex in anticipation of all the Bank Y dividend strippers buying Bank X when Bank Y goes Ex (lost you there I expect).
* Imputation credits are now the equivalent of cash because you can claim them from the ATO. It used to be you could only offset them against income tax.....so non tax paying funds (super funds) had no use for them. This is not now the case. Franking credits are of use to pretty much everybody whether they pay tax or not. Super funds should now be collecting franked dividends because franking credits are cash....you can claim them back as cash....you do not need to be paying tax to make use of them. So super funds should work the dividend season hard, especially those funds that are already supporting their members and are focussed on income.
* It is a wonder that brokers continue to quote yields without including the franking amount....maybe because they are writing research for international fund managers (who don't get franking) as well as us. But the gross yield is the yield for all intents and purposes if you are an Australian Mum, Dad, Super Fund or allocated pension.
* Some companies go Ex Dividend very soon after results (usually the larger high credit rating stocks like the Banks). Others go Ex Dividend months after results. You need to be aware of this when stripping. The Banks for instance usually go Ex the Monday after the week of their results. Some companies like Telstra used to go Ex 6-7 weeks after results. Worth understanding whether your stock pick is a late payer.
* The Ex date is not the 'pay' date. There is a set 'pay' date for each dividend...the date the cheques are sent out.....well after the Ex date usually. You can see the Ex and Pay dates on the table of dividends that have been declared at the bottom of this newsletter every day.
* Retain your dividend statement from the company....it has your imputation entitlement on it. You will need it to claim the credit back from the tax man when you put your tax return in. You will need the imputation paperwork. * There are other issues with partially franked dividends too complex to explain...the catch all is to make sure the company has your TFN every time by putting your TFN on every transaction through CHESS and you will ease the complication.
DEALING COSTS
* Some brokers suggest dividend stripping is a little like negative gearing....nice concept but pointless unless the underlying asset price rises as well.
* Dealing costs are the biggest concern when dividend stripping. In fact dealing costs can make the whole process pointless and often you would not strip dividends if you did the numbers. It is no good buying and selling a stock for a 2% dividend yield and paying 1% commission on the buy and 1% on the sell. Dividend stripping dealing costs can make it not worth the risk. In a rising market fine....but in a flat or falling market the costs will often negate the gains. So when dividend stripping you need to minimise your dealing costs....somehow.
* Some brokers also suggest that by the time you have sold CBA to buy ANZ sold ANZ and bought back CBA you have in fact switched four times instead of twice and your dealing costs are 4%....not 2%. In which case that will dwarf most dividends you pick up.
* What all this means is this....dividend stripping will only really pay off when the stock you buy goes up in price as well. Luckily....in a low interest rate environment....big income stocks are prone to perform well over the dividend period because people do chase the dividends.
* When you consider the costs it becomes pretty clear that in order to make good on dividend stripping you really need to be buying good stocks, in a rising market...that just happen to be going Ex dividend.
WATCH OUT
* Some stocks have big yields because they are dogs. If the share price has fallen a lot and brokers haven't changed their dividend expectations then some stocks appear to have enormous yields. So when a stock comes to your attention because of the size of its yield alone....have a look at the share price chart. If this shows a tumbling share price then watch out. Don't buy before the results.....they may well cut the dividend pay-out despite what the consensus forecasts appear to say.
* Even if one of these struggling companies maintains its dividend after results and really does have an enormous yield...watch out again. Stocks like this are unlikely to be trending up....(so you may lose money during the holding period).....and when they go Ex dividend they can drop hard and drop again as the people who bought it for the dividend and not the fundamentals dump it again.
* All in all....if the stock has been a terrible performer....and that is why the yield is so high....you had best just leave it alone. No good buying a rubbish stock for any reason.
* If a stock yields close to 10% before franking....the likelihood is....it doesn't.
THE PERFECT DIVIDEND STRIP - You buy a bank share 46 days before the Ex Date. The stock has results. They are good and the share price rises. The stock goes Ex Dividend. The share price carries the dividend and closes up that day. You sell with a capital gain, entitlement to the imputation credit and you get a cheque for the dividend plus franking. Your broker rings you to say how much he loves you for churning your stocks around.
THE NIGHTMARE DIVIDEND STRIP - You read a bit of research about a small retailer that quotes a consensus forecast yield of 10.5% and it is fully franked. Results are coming up so you decide to buy early to get a head start on the 45 day rule. The stock falls ahead of results. The results are terrible and the dividend is cut. But it is still a big dividend yield so you hold on for the "Ex date". The stock slides into the ex dividend date. Once it goes EX 10c the share price opens up down 14c (the dividend plus the franking) and sellers beat you to it and it falls 20c. It then continues to trend down in a very illiquid market. You start asking questions. Seems you failed to notice the 15% fall in the share price after a profits warning a month before you bought in. The reason the stock had a 10.5% yield is because the share price had fallen and the yield was based on a pre-profit warning dividend forecast. Your mistake - feeling the width without a concern about the quality. You sell it - then of course it bounces. Moral - Only buy stocks for the dividend that you would be quite happy to hold long term if the strategy went oblong in the short term.
THE 50% YIELD - I have seen people losing a bucket of money this year in some infrastrcuture stocks. "But they have a big yield, they're a safe stock" cries one adviser looking at Babcock & Brown Power (down from 380c to 206c). So I tell him this. "You give me a dollar and I'll guarantee you a 50% yield for two years". "Really" he goes. "Yep" I say. He gets a dollar out of his pocket. Of course all I do is pay him 50c of his own money in a year and 50c in two years. I keep the interest on the money for two years and at the end of two years the capital value of his investment is zero. I have simply given his money back.
Moral - Yield is nothing if the capital value of the investment falls - a high yield does not mean "safe".
THE UNCANNY SCOTSMAN
One of my institutional clients used to be a Scottish income fund. When I was initially talking to the fund manager about the income requirements of the fund he simply said "Feel the Width". In other words - he was interested in one thing - big dividends. Stripping dividends wasn't his game he said, apparently he was in the business of investing in quality high income stocks. But the truth was this, he worked the dividend season like a dervish, trying to successfully strip dividends without losing capital. That was his job. But he had a couple of rules
* Buy early - As an income fund he had to buy before the whole market started chasing quality stocks ahead of results and dividends. It was his bread and butter to make money out of the rest of the market getting excited about results and dividends.
* Never sacrifice capital for income - One of his famous explanations was "lend me a pound and I'll pay you a 10% yield pa for ten years. Sound attractive? At the end of ten years I'll send you a letter saying that unfortunately the fund is now worthless - thanks for the lend of your money". In other words income alone means nothing. You have to balance it with a good investment. Anyone can pay a high yield. You have to overlay yield with a quality factor. A high yield is often an alarm bell not an asset.
* If it goes up a lot before the dividend - sell it. Cash is cash whether it comes in income or capital gain. There is plenty of money to be made trading stocks for the run up to results and the dividend without actually picking up the dividend.
