Profits from Capture-the-Dividend Plays

by Jonathan Yates | January 13, 2012 2:35 pm

With the Standard & Poor’s 500 Index flat for another year, dividend income has become even more vital.  According to mutual-fund legend John Bogle in his book Enough, dividends have historically provided over 40% of the total return in the market. Since the financial markets were flat for the last decade, that means the capital-gains segment of an equity was -60% of the total return. For investors, money in stocks that don’t pay dividends hasn’t just been “dead money” (in that there was no income), it’s been zombie money — eating into the total returns of the body of the portfolio.

This does not seem likely to change for either stocks or bonds. In an article in Smart Money magazine by Ian Salisbury, “Trust Me, I’m a Fund Manager,” William Eigen, manager of J.P. Morgan’s Strategic Income Opportunities Fund, notes that “there’s no income in fixed income.” And Bill Gross, the “bond king” who’s head of Pimco, is recommending dividend stocks. Since the entire basis of investing is the time value of money, leaving funds dormant for all but the four dividend-paying days of the year is hardly efficient.

Capture-the-dividend trades allow investors to maximize return on capital by owning a security for the days when it goes “ex-dividend” — paying out to the shareholders of record. The security, be it a stock or an exchange-traded fund, is bought before the ex-dividend date, then sold quickly for a profit.  Capture-the-dividend trading is the ultimate transaction for “the perfect trading day” — i.e., ending with all positions closed.

Surprisingly, stocks associated with conservative, long-term investing, such as utilities and consumer companies, are ideal. Most importantly, these stocks pay healthy dividends. Pepco Holdings (NYSE:POM[1]), the utility for the Washington, D.C., region, pays a dividend of 5.37%. Altria Group (NYSE:MO[2]) is a consumer giant with a dividend yield of 5.67%[3]. AT&T (NYSE:T[4]) offers dividend payments of 5.91%. The average dividend for a stock on the Standard & Poor’s 500 Index is around 2%.

While capture-the-dividend plays are similar to day-trading if executed adroitly, the ideal stock is one that’s not volatile. Since the object of capture-the-dividend trading is to book the gain and then sell quickly, a trader won’t want to get caught on the wrong side of a wild swing.  Again: “Widow and orphan” stocks are the most suitable. AT&T has a beta of 0.60, while overall market volatility is 1. That means AT&T moves less than two-thirds as much as the market. The beta for Altria Group is 0.42. Potomac Holdings’ is 0.51.

Your target company should also be listed on the New York Stock Exchange, so there isn’t a wide gap between the “bid” and the “ask” price. This protects the individual from being abused by market makers. If the stock is listed on the Big Board, volume is most likely strong as well. Investors do not want to be the market in capture-the-dividend transactions. With the daily volume for Potomac Electric at 1.84 million shares, 25.30 million for AT&T and 13.55 million for Altria, that is not a concern.

To mitigate transactions costs, investors have several options. Trading in a retirement account will allow for the gains to be tax-free. In addition, since you can’t go on margin in a retirement account, there’s a built-in hedge against a trade gone awry. Investors can also elect to utilize capture-the-dividend trades with tax-free bond exchange-traded funds.

The most important reason to deploy capture-the-dividend trading is the rarity of it: Investors know what the dividend payment will be and when it will be paid, since the board announces that info in advance. How many other plays can you name that have zero uncertainty?

  1. POM:
  2. MO:
  3. with a dividend yield of 5.67%:
  4. T:

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