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XMFSinchiruna (28.57)

Think Twice Before Diving for Dividends

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July 19, 2010 – Comments (24) | RELATED TICKERS: WY , MSFT , AMTD

I am very curious to know how many Fools among us truly understand the nature of dividends.

If you thought dividends were like free cash money with no strings attached aside from taxes, then you might just be in for a big surprise.

In the wake of the Weyerhaeuser $5.6 billion dividend announcement, I was amazed to discover just how many folks planned to dive into the stock to reap the huge dividend as if it were some sort of glorious windfall. 

Those who did understand that dividends are negated in their entirety by a commensurate re-pricing of share prices BY THE EXCHANGES (I personally thought the market was responsible for the repricing before researching this article), I wonder if you might share a story about how you learned this lesson ... perhaps you were once a dividend diver as well?

I am so curious to learn just how common a misperception this is, that I will post a poll to this blog post so people can vote in order to gauge the extent to which dividends are sufficiently understood by lay investors. Please take a moment to read the article, rec it if you appreciate the content, and vote in the poll linked in a forthcoming comment below.

Thank you!

Think Twice Before Diving for Dividends

http://www.fool.com/investing/dividends-income/2010/07/16/think-twice-before-diving-for-dividends.aspx

Excerpts:

"Psst! Hey, kid! You want $5.6 billion?"

The obvious answer is "yes," right? But what if you had to give up $5.6 billion to get the payout? While I don't know any kids with that kind of dough, even Richie Rich would know to leave that deal alone.

In the days since Weyerhaeuser announced the special dividend, unfortunately, I have encountered multiple indications that some investors out there may be piling into Weyerhaeuser shares with dreams of turning a quick and tidy profit on this apparent windfall.

It probably didn't help matters that Jim Cramer recommended Weyerhaeuser shares back in May -- when the shares traded 17% higher than they do today. Emboldening potential dividend divers, Cramer stated: "I think you want to be in front of this Weyerhaeuser conversion, and own the stock ahead of the news."

In one financial forum, an investor claimed to have purchased 100 shares of Weyerhaeuser after the dividend announcement, with intentions to sell the stake right after the distribution for a quick 50% net return on investment (after taxes).

If only investing were that easy!

To wash away any misconceptions you may have about dividends, I recommend this excellent two-part series (Part 1, Part 2) penned by our own Jim Mueller a few years ago. You may not realize it, but even those coveted quarterly cash distributions from your favorite income stock [are] effectively canceled out by a commensurate downward share-price adjustment conducted by the exchanges. Those share adjustments are normally quite small, so many investors may not even realize they occur.

Since share prices are adjusted downward to account for the exchange of cash and shares from the company to shareholders, dividends are essentially a zero-sum game.

So there you have it, Fools. The next time you overhear a fellow investor hatching a plan to strike a quick fortune by gaming a juicy dividend, you will be equipped to explain in no uncertain terms why such a strategy will only end in humbling disappointment. You will recall the adage, "if it sounds too good to be true, it probably is" … and you will notch yet another valuable lesson learned since joining the ranks of the Motley Fools.

24 Comments – Post Your Own

#1) On July 19, 2010 at 6:54 PM, XMFSinchiruna (28.57) wrote:

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#2) On July 19, 2010 at 7:26 PM, starbucks4ever (99.49) wrote:

"Since share prices are adjusted downward to account for the exchange of cash and shares from the company to shareholders, dividends are essentially a zero-sum game."

And since share prices are also adjusted downward to account for the loss when the CEO misspends the money retained by the company, lack of dividends is a negative sum game. 

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#3) On July 19, 2010 at 7:30 PM, chk999 (99.98) wrote:

There are two actual questions about dividends. The first is do you need the money for income? If you have bought divi paying stocks for income, then you absolutely want a sustainable dividend paid out.

The second question is can you compound the money at a higher rate than the company can? If so, then they should pay dividends and you should re-invest them in your better opportunities. If not, then the company should retain the earnings and reinvest them for you. 

Buffett can compound faster than most companies, which is why he likes dividend paying stocks, but Berkshire itself pays no dividend. 

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#4) On July 19, 2010 at 7:46 PM, allstarvulture (< 20) wrote:

I'll agree that dividends are an aspect of investing that require as much research as any other facet, and by no means should be taken for granted.  But there's another aspect to consider with the following passage:  

Since share prices are adjusted downward to account for the exchange of cash and shares from the company to shareholders, dividends are essentially a zero-sum game

Unlike gains realized solely from capital appreciation, dividends allow for a potential return on investment without having to relinquish any ownership in the enterprise.  Yes, the price of my shares will decrease (hopefully only temporarily), but my ownership stake does not. 

I do agree with your final paragraph, though.  Dividend investing is not, and should not, be about getting rich quick.

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#5) On July 19, 2010 at 8:29 PM, SockMarket (87.36) wrote:

sinch,

since share prices are adjusted downward to account for the exchange of cash and shares from the company to shareholders, dividends are essentially a zero-sum game.

 

you are correct that special dividends do drop the stock price by an equivalent amount (well close, and the taxes make up the rest) over the long run, however this is not true with ordinary payouts.

If you will look at the PG's or JNJ's of the world you will notice that the stocks immediatlly drop but then recover very quickly. Even when you take ED, which no one in their right mind would buy for anything but the dividend, and you will see that the pattern holds.

I don't think it is that the company is always undervalued every 3 months, rather I think that the expected dividends are already priced into the stock and that when they drop for the div people jump on board. Report this comment
#6) On July 19, 2010 at 10:32 PM, MegaEurope (22.67) wrote:

I'm not sure I believe Mueller's claim that the exchanges lower the share prices to correct for dividends.  It seems like this would be done by the market makers.

According to Wikipedia "Dividend": "The company does not take any explicit action to adjust its stock price; in an efficient market, buyers and sellers will automatically price this in."

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#7) On July 19, 2010 at 11:20 PM, Dobbes (< 20) wrote:

I happen to prefer stocks with dividends because I lean towards older, mature, slower companies with my real investments.  Without the dividend component, their total return will often lag the general market.

As far as investing in a stock ONLY for a dividend, it is a fool's errand.  I did investor relations for Morgan Stanley when they cut their dividend in the summer of 2009.  I could not believe the number of investors I talked to that had invested solely for the purpose of generating income with a good yield, thinking that they would never have to touch their money again, pay attention to the stock price, or that the dividend checks would ever stop.  These investors were forced to liquidate.

Never be in something as volatile as a stock for income investing.  The risk to your principal is just too great. With the exception of a few O&G trusts, capital appreciation far outpaces dividend payouts as a component of total return for stocks.

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#8) On July 19, 2010 at 11:21 PM, TMFBabo (99.99) wrote:

Like a few others have noted, I think it depends on your investment horizon.  If you plan on holding long-term and improving your yield on cost year after year, I think the right move is to find a solid dividend grower like PG and hold it as it increases distributions every year.  Those short-term fluctuations matter not unless you're going for capital gains more than dividend income.

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#9) On July 20, 2010 at 8:12 AM, silverminer (36.91) wrote:

danielthebear

Daniel, That is precisely the misconception of which I speak. It's not just special dividends, but in fact for every normal cash dividend that is paid out the share price is adjusted accordingly (BY THE EXCHANGES ... NOT THE MARKET!).

Now, the per share amount of a cash dividend for a normal quarterly payout is generaly quite small, and therefore is lost within the noise of a given trading day, but without attempting to account for investor psychology and any tendancy to jump in on miniscule downward blips, the fact is that the exchanges calculate and execute a downward revision of a share price that is precisely commensurate (not approximately as you suggest above) with the per share distribution on the ex-dividend date.

That may be another source of the confusion that's out there ... shares are repriced on ex-dividend date, not the date of the payout.

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#10) On July 20, 2010 at 8:16 AM, silverminer (36.91) wrote:

MegaEurope

Wikipedia is wrong.

If you're looking for relative expertise between Wikipedia and Jim Mueller, I suggest you give Mr. Mueller the time of day.

It's not a claim, but a fact. That being said ... I shared the same misconception about the market being responsible for repricing, and I too was a bit incredulous when the information was first brought to my attention.

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#11) On July 20, 2010 at 8:18 AM, silverminer (36.91) wrote:

Dobbes

Interesting comments ... thank you

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#12) On July 20, 2010 at 11:15 AM, MegaEurope (22.67) wrote:

Prove it, Sinch.  I'm a reasonable guy.  Or did I miss some evidence that you posted already?

If it's true, you should be able to provide evidence from the SEC, Nasdaq, NYSE, a brokerage, a major newspaper, or another financial publication besides TMF, right?

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#13) On July 20, 2010 at 11:51 AM, silverminer (36.91) wrote:

http://www.investopedia.com/articles/stocks/07/dividend_implications.asp

On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend by the exchange on which the stock trades.

As I review archival articles on the topic, however, the fact is I find about equal coverage claiming each of the processes to be the truth. This misconception exists among financial professionals as well as among lay investors.

There's a MarketWatch article that gets it right, and a Seeking Alpha piece that gets it wrong. 

I've put several days of research into that article, had it fact-checked by our editorial staff, and confirmed by our in-house financial guru. If you claim to know that the exchanges do not adjust share prices to reflect dividend payments on the ex-div date, some portion of the burden of proof now lies with you as well. I concede that the freely available record of information on the topic is woefully inadequate, and as an industry a horrible job has been done in communicating these issues to the public.

It shouldn't be hard for us to find reliable confirmation of one explanation or the other, but the truth is ... it is.

I too am a reasonable guy. I believe that Jim is correct, but I am willing to review any and all evidence to the contrary. I was not able to find relevant information on the website of the NYSE in a cursory look, but I also lack the time to delve deeply. I wil ask Jim for a reference.

 

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#14) On July 20, 2010 at 12:52 PM, MegaEurope (22.67) wrote:

I just emailed the queston to press contacts 'eryan@nyx.com' and 'communications@nasdaqomx.com'.

Hello, I understand that the exchange sets ex-dividend dates based on information provided by listed companies and also adjusts the price of some open orders.  Does the exchange also adjust the price of shares on the ex-dividend date, or is that handled entirely by market participants?

This is in reference to an article in The Motley Fool:http://www.fool.com/investing/dividends-income/2010/07/16/think-twice-before-diving-for-dividends.aspxhttp://caps.fool.com/Blogs/think-twice-before-diving-for/421956 

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#15) On July 20, 2010 at 12:55 PM, MegaEurope (22.67) wrote:

*question

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#16) On July 20, 2010 at 1:14 PM, silverminer (36.91) wrote:

MegaEurope

Cool ... thanks. :)

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#17) On July 20, 2010 at 3:38 PM, silverminer (36.91) wrote:

MegaEurope

I just confirmed it with an independent expert. The price adjustment is indeed executed by the exchanges. The market is not involved. Because of who it was that just corroborated the point, it's 100% case closed from my perspective, though I will still pass along the reference that Jim will be sending along when he gets a chance. 

I still invite Fools to post links here to any sources they find on the topic, whether they are based upon the misconception or promoting the proper understanding. I am curious to develop an even stronger idea of just how widespread the misconception is... I think it is likely to be something of an epidemic.

Thanks all for your input.

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#18) On July 20, 2010 at 4:41 PM, MegaEurope (22.67) wrote:

The guy I talked to at the NYSE said that the exchange adjusts the closing price the day before ex-div, but then the opening proceeds as normal the day of ex-div.  Of course, there is no guarantee that the stock will actually trade for the adjusted price - it may open higher or lower.

I think we are both "right", we are just talking past each other.

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#19) On July 20, 2010 at 4:56 PM, Rehydrogenated (35.14) wrote:

Shorted stocks get a nice boost before a large dividend payout. That's because shorts don't want to post the cash for the dividend (because they may be able to compound that cash faster than the company can dispound it :P). I don't think that was the case for WY, but it is often the case for companies with a high dividend yield because their company is facing a lot of risk or their business is in decline. It also explains why these companies seem to recover their dividend readjustment so quickly.

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#20) On July 20, 2010 at 5:00 PM, silverminer (36.91) wrote:

Mega,

Thank you for checking into that. I don't think we were talking past each other at all .. on the contrary, I think these are all crucial details to iron out.

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#21) On July 20, 2010 at 7:11 PM, silverminer (36.91) wrote:

Jim offered this corroborating source:

http://findarticles.com/p/articles/mi_m4130/is_3_34/ai_n15954501/

"Our key observation is that the TSX does not have an ex-dividend day limit order adjustment mechanism like those of the NYSE, AMEX, or Nasdaq."

This article seems to suggest that the mechanism for effecting a share price adjustment is via a re-pricing of limit orders. 

However, Mega's discussion with an NYSE rep suggests that the actual prior-day closing price is adjusted.

I sure wish there were one comprehensive source out there that could make this entire issue crystal clear down to every detail. Thus far I have encountered no such source.

 

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#22) On July 22, 2010 at 7:01 PM, megalong (< 20) wrote:

I think the answer depends how you define "pricing".

The exchanges don't "set prices", only people buying and selling on the market can do that.  The exchanges just execute orders and report the prices.  The day before ex-dividend, they report an adjusted closing price, along with the information about the dividend.  I believe if a stock closed at $100 the day before, $102 that day, and was going ex-div $5 the next day, the adjusted closing price would be shown as $97, +2% (not -3%).  (I need to confirm that is the way they show percentage change, I am not sure about it.)  In order to note that it is an adjusted ex-dividend price, the symbol will have an 'X' next to it in a newspaper and possibly other sources.

You are right, the American exchanges also adjust open limit orders. I think this is intended to help unsophisticated investors avoid getting tripped up.  After all, just because dividends are made public does not mean everyone who owns the stock knows about them beforehand.

I read through all three sections of NYSE dividend rules ... they have hundreds of sections of rules on their website.  But I didn't find anything about ex-div closing price adjustment.  The rep had to explain it.

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#23) On July 22, 2010 at 7:03 PM, megalong (< 20) wrote:

That is a very interesting article.

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#24) On July 26, 2010 at 11:54 PM, Valyooo (99.79) wrote:

I thought this was common knowledge.  I learned this myself from dividend diving once within my first month of trading.

However, this is why dividends are actually a plus...

 

Lets say a company is worth $50/share.  They pay a $2/share dividend.  The stock therefore has a 4% yield.   After the dividend, the share price is $48.  If the stock doesnt appreciate it now pays a 4.2% dividend.  If it still doesnt appreciate and pays another $2, the price is now $46 and pays a $2 dividend.  Etc etc, the stock price lets say eventually goes down to $2.  It now pays a 100% yield.  Just because the share price goes down does not mean the company doesnt generate cash.  So now youre making a huge return on investment.

If a company sits on a bunch of cash instead of paying dividends, the market sentiment can drag it down to $2 .  But you wont be getting anything from the company.  

 

So in my opionion, dividends keep stocks from being meaningless pieces of paper with systematic risk written all over them 

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