Maximize Income With Dividend Capture

This article is the first part of a series that details the dividend capture strategy.

Most dividend investors are focused on consistent cash flow and modest to intermediate capital appreciation. However, dividend stocks are also the target of another type of investing strategy called the dividend capture. The dividend capture is simple to explain, but can be complex to pull off successfully. This article will focus on:

1. The mechanics behind the dividend capture strategy

2. The reasons why the dividend capture strategy exists

3. Examples displaying price behavior surrounding dividend dates

The Mechanics

A dividend capture is a trading strategy that focuses on buying a dividend paying stock on the last day that you can in order to be paid the dividend (called the cum-date), and selling the next trading day (called the ex-date). In theory, the stock price should drop the same amount as the dividend at the open on the ex-date. Nevertheless, the price hardly ever adjusts exactly to the dividend, and some companies actually display a significant amount of price resilience on a consistent basis.

Before reading any further, be forewarned that a myriad of academics have spent years trying to prove that there are no profits to be made by trading this strategy. However, a lot of smart people working at a lot of prestigious financial firms around the world have run this strategy on a long-term basis; some of which are running their own money alongside their investors.

Why Dividend Capture Strategies Exist

For the most part, a standard dividend capture website or book will make it seem like the strategy is an easy way to retirement. Unfortunately, many opportunistic investors following such guidance have watched their wealth dwindle as they flounder around in the market trying to grasp 25 to 50 basis points a day. There are very good reasons why this strategy is not fool-proof and is not implemented by everyone.

I suggest that three main reasons limit alpha:

• Transaction Costs: Depending on your broker, transaction costs can be steep. Assuming brokerage fees of $10 per transaction ($20 for getting in and out), your return can be whittled down immensely. Unfortunately, even with commissions as low as they are, this alone can be a deal breaker for a small individual investor. For instance, if you dedicated $2,000 to this strategy and found a killer trade of 1%, you would only break even net of fees.

• Tax implications: The dividend capture strategy creates daily taxable events. By trading this strategy, an investor will get cash that will be taxed at their regular income level. The stock will be held for roughly one day, and will therefore not be considered for the qualified dividend rule. For example, if your return for a day (without transaction costs) is 1% and your tax rate is 25%, your after-tax return is 1%*(1-.25) = 0.75%. Of course, this whole issue goes away if you are in a tax advantaged account such as a Roth IRA, or hold the stock long enough to invoke the qualified dividend (expiring with the Bush tax cuts).

• Other Market Participants: Dividend capture strategies can be profitable. To that end, many other investors will attempt to juice as much of a return as they can from it. Some large institutions are happy with only a few basis points a day. I make this point only to highlight that in many cases, the price of a stock will act pretty crazy around the cum- and ex-dividend dates.

Example: Standard Dividend Price Behavior

Many times, you will see a large run-up of the price right up until the cum date closing and a drop into the abyss the morning of the ex-date. As an example, here is a chart of Eli Lilly (LLY), which recently went ex-dividend on November 10th. Click to enlarge:

LLY vs GSK vs SPY: LLY Shows Negative Alpha starting 11/10/2011

As you can see, LLY outperformed both GSK (GlaxoSmithKline; a competitor) and the SPY (S&P 500 ETF; market proxy) up until Wednesday (the cum-dividend date). On Thursday, once LLY was trading without the dividend, it followed the market down until 11:00 AM, but never rebounded like GSK or SPY. Dividend traders are excited to get into a stock (result being outperformance on days leading up to cum date), but want to dump it right on the ex-date (leading to an oversupply of shares, and subsequent underperformance). I’m sure this is not a perfect example, since there may have been significant news developments. However, the general trend is consistent enough to note.

Example: Abnormal (Positive) Dividend Capture Opportunity

Although many stocks follow the same type of price pattern as the LLY case above, some stocks do not. As an example from the same time frame, we will use Manulife Financial (MFC), which also went ex-dividend on November 10th. Click to enlarge:

MFC vs SPY: Bought at highest price after 3:00 PM Cum Dividend.

In this example, the stock price did experience an abnormal drop before the end of the trading day. This is somewhat uncommon, so I’m going to assume that you bought at the high towards the end of the day (3:22 PM @ 12.07). We would hold our shares overnight and sell them the next morning (usually as soon as you could). Most likely, you would sell somewhere between 9:30 AM and 10:00 AM, which would give you a return range of 1.16% to -0.25%.

Consistent Dividend Capture Profits

As stated previously, there are many firms that maintain a dividend capture strategy portfolio. Some are successful and some are not. My next article will focus on how some of these firms analyze, select, and execute their strategies. As well, I will offer an additional framework and turnkey solution that can be useful in your own dividend capture trading.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.