Dividends, franking credits, and capital gains

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Reporting season will be here before you know it — many of Australia’s largest companies announce their half yearly results in February. These results are often followed by companies’ half yearly dividend payments.

With investor favourites such as Telstra, Woolworths, BHP Billiton, and Commonwealth Bank set to make distributions, you might be considering ‘dividend stripping’.

Dividend stripping is a short term strategy. It involves buying shares several weeks before the ex-dividend date, and selling after they go ex-dividend. If all goes to plan, you’ll get the dividend plus its franking credits, and you’ll bank a nice share price gain when you sell the stock.

Franking credits, if you’re not aware, are a tax credit equal to the amount of corporate tax paid by the company. They’re quite valuable — you can offset them against your tax bill or receive them as cash if you pay little or no tax.

Share prices often rally in the lead up to the ex-dividend date as investors jump on board to receive the dividend. Then, once a stock goes ex-dividend, the share price typically falls by around the amount of that dividend.

This is where the opportunity lies. Buying early means you’ll get the run up in the share price before the ex-date. The following fall in the share price is usually less than the value of the grossed up dividend — that is the dividend plus its franking credits. So if a company pays a 10 cent fully franked dividend, the share price usually drops by around 10 cents — not 10 cents plus the franking credit. And assuming there is no unexpected, unwelcome news, share prices usually recover soon after.

To make sure you receive the franking credits, you must hold the shares ‘at risk’ for at least 45 days — not including the days on which you buy and sell. However, this rule doesn’t apply to small investors who receive franking credits of less than $5,000 for the year. That’s around $11,666 in fully franked dividends. Assuming the ASX 200’s average yield of 5%, if you have a portfolio of less than approximately $230,000 you can ignore the 45 day rule.

Many people have a lot of success with dividend stripping. But it’s important that’s it’s done correctly.

Target big companies with large foreign ownership. Foreign investors don’t receive any franking credits, so large foreign shareholders will often sell ahead of big dividends and buy back later — creating opportunities for local investors.

Bank shares are a good example. Their share prices find support from their consistent dividends and stable operations. In the months leading up to a bank’s results, its share price will often rally. And if the result is good, the stock will fall by less than the dividend amount plus franking, or even continue to rise after going ex-dividend. You then sell the shares, banking the dividend and its franking credits, plus a capital gain (or just a smaller capital loss).

The risk is that the strategy goes horribly wrong. A day after going ex-dividend, some shares will fall in price by more than the dividend amount. This is more common in shares that are paying large one off dividends, or that have few reasons for the share price to rise.

Consider the following scenario. You identify a small mining stock with an impressive yield of 10%. You buy it 46 days before it goes ex-dividend, but the company announces weak results and the share price falls. Following a difficult half year, the company cut their dividend. Once it goes ex-dividend the share falls by more than the dividend amount plus its franking…and keeps falling.

The high yield was due to a falling share price and the dividend was unsustainable. A better idea is to buy large high quality stocks with a rising share price that just happen to be going ex-dividend.

If you’d like to try this strategy, you should keep these rules in mind:

  • Stick to big well-known companies that pay reliable dividends.
  • Target companies with high foreign ownership
  • Avoid companies with falling share prices, recent profit downgrades, or with unsustainable dividend yields.
  • Only attempt this with quality companies that you wold be happy to invest in otherwise.

This is a high risk strategy with no guarantees. And since the returns can be so variable, you’ll need to do a large number of trades to adequately reduce your risk. So keep an eye on transaction fees. They can quickly add up when switching between stocks, especially if you are only trading small amounts.

I have recommended some excellent dividend stocks in the Albert Park Investors Guild — stocks consistently raising their dividends, or paying bonus ‘special dividends’ year after year. However, as part of a wealth building, low risk strategy, I prefer to hold them longer term rather than taking the risk of trying to perfect dividend stripping.

If you’d like to learn more, I share all the details here.

Meagan Evans
for The Daily Reckoning Australia

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Meagan Evans
Meagan Evans, has seen from the inside of the investment industry how easy money can lead to bad management decisions. She holds a degree in Finance and a Master’s in Business Administration and, as a Certified Financial Technician, Meagan employs both technical and fundamental analysis to make solid investment decisions
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