‘Buy and hold’ investing is often touted as the most conservative way of investing in shares. After all, aren’t shares supposed to go up over time?
As profits and dividends grow, so too should share prices, to reflect the increased value of the underlying business. Just ask anyone who bought Commonwealth Bank [ASX:CBA] shares back in 1991 for $5.40.
Now trading at around $78, and having paid $4.20 in dividends over the last 12 months, CBA trades on a current fully franked yield of around 5.4%. However, anyone who bought shares way back in the float is sitting on a yield that’s closer to 80%. That’s around 35 times more than what you’ll get with a term deposit!
Of course, if you bought into CBA anywhere near the float price, you’re not going to be too worried about the risk to your capital. The current dividend is going to pay for your original purchase cost every 15 months or so.
If you didn’t get in on the float, but wanted to enjoy those juicy dividends at current prices, that’s going to require a lot of capital. Not only that, to participate in the dividends, you’ll need to hold on to your position throughout all the market gyrations…which is easier said than done, especially with dividends only coming twice a year.
However, there is one way to participate in those dividends without having to hold on to the shares throughout the year — it’s called dividend stripping.
It doesn’t just apply to the CBA, of course. You can apply this strategy to any dividend-paying share in the market. But it’s not without its risks. Before I get to those, I’ll explain what dividend stripping actually means first.
The idea is that you buy into a stock prior to its ex-dividend date, making you eligible for the upcoming dividend. Anyone who buys a stock on the day it goes ex-dividend (or after) won’t be on the share register by the record date, meaning that they’ll miss out on the dividend.
After qualifying for the dividend, the investor then sells out of the stock and waits for the dividend payment to hit their bank account.
It sounds like a neat little plan. But, as you know, the market is a bit harder than that. It rarely, if ever, hands over such nice little gifts.
As the theory goes, the share price should drop by the amount of the dividend, the day the share goes ex-dividend. So a company trading at $10 per share, that goes ex-dividend for 50 cents per share, will now be worth $9.50, all else being equal. But this is where it can get tricky.
For a start, in a bull market, the shares might drop less than the dividend amount as investors continue to pile into the stock. While the dividend would no doubt be a bonus, these investors are buying in on the prospect of a capital gain. It’s this type of market that really suits a dividend stripping strategy.
Where you need to be really careful, though, is when a stock is in a downward trend. Quite often, shareholders might just be hanging in and waiting for the dividend to come through. The moment the stock goes ex-dividend, they might start heading for the exit.
With more sellers than buyers — the price might fall a lot more than the dividend amount. This is purely a function of demand, as there is little to entice buyers into the stock. Not only does the buyer miss out on a dividend, they’d be buying against the underlying trend too.
Undertaking a dividend stripping strategy on a stock in a downward trend is an almost sure-fire way to lose some money. The capital loss from the drop in the share price will almost always exceed the income generated from the dividend.
Why do investors do it then?
Primarily, it has to do with any franking credits attached to the dividend, as they can be reclaimed when it comes time to lodge a tax return. An investor could claim the capital loss from the drop in the share price, but then receive franking credits on the income generated from the dividend. But, as you can imagine, this isn’t something the tax man is too happy about.
That’s why the ATO introduced a holding rule. In order to qualify for the franking credits, investors need to hold the shares for a minimum of 45 days, not including the buy or sell date. As the ATO states:
‘The holding period rule requires shares to be held ‘at risk’ for a continuous period of at least 45 days (90 days for preference shares) during the qualification period.’
‘The 45 day and 90 day periods don’t include the day of acquisition or, if the shares have been disposed of, the day of disposal. Also excluded are days where the financial risk of owning the shares is materially diminished.’
This last point is important. You can’t hedge the entire share position while waiting to satisfy the holding rule. Otherwise an investor could use the strategy as a limited (or no risk) way of picking up franking credits.
What often gets overlooked, though, is that there is a small shareholder exemption for those that receive less than $5,000 of franking credits in an income year. As always, though, check in with your accountant to make sure you understand the rules.
Allowing for transaction costs as well, you really need to time your share purchases to get a dividend stripping strategy to work. Often the share price will rally into the ex-dividend date, as investors buy in to take part in the distribution. The idea is that you buy into a stock before the price starts to rise.
However, that leads to another risk — the stock could always fall, like on a profit downgrade leading into a result, for example. That’s why you need to always check both the date the company releases its results, and the day the stock goes ex-dividend, before looking to place the trade.
You only want to apply a dividend stripping strategy to a stock you’re ultimately prepared to own. Meaning that you wouldn’t want to risk your capital on a stock just to pick up a dividend and some franking credits.
If you get it right, you can pick up capital growth in the shares, the dividend, and the attached franking credits. Now that’s a pretty good scenario.
However, if the opposite happens, like a profit downgrade and cuts to the dividend, you could get hit twice. Not only on the income side, but the potential drubbing of the share price as well, as the market reacts to the bad news.
For The Daily Reckoning