Constructing Dividend-Paying Stocks Strategies

Dividend-paying stocks provide investors with tangible returns on a regular basis regardless of market conditions. This can benefit a range of investment styles and management strategies — from completely passive indexing to active buy-and-hold selection to aggressive trading and arbitrage.

Passive Dividend Portfolios

In 2014, a portfolio composed of all stocks in the S&P 500 index would have paid dividends of approximately $39.44 in addition to any price appreciation. However, the portfolio itself can be divided into dividend-paying and non-dividend-paying stock portfolios. As of December 31, 2014, there were 423 dividend-paying stocks and 77 non-dividend-paying stocks in the index. An equal-weighted portfolio of the dividend-paying stocks would have returned an annualized 8.9% during the ten years that ended on that date, while the non-dividend-paying issues would have paid 9.7%¹. Since a typical passive portfolio is constructed to mirror the composition and performance of a broad market benchmark such as the S&P 500, a passive investor can seek to harvest dividend income potential simply by focusing on the dividend-paying constituents of that index.

Active Buy-and-Hold Selection

Fundamental stock screens can be adapted by adding various dividend attributes to the screen criteria. One key question is whether or not the company has paid a regular dividend and, if so, how much and for how long? Another is whether the company has been able to increase the amount of the dividend over time and, if so, by what rate? Studies have shown that the buy-and-hold strategy of investing in companies that increase their dividends steadily over long periods of time can outperform. For example, the Standard & Poor’s Dividend Aristocrats portfolio is made up of the firms in the S&P 500 that have increased their dividends steadily for at least 25 years. Despite the very strong year for stocks overall, the Dividend Aristocrats portfolio nearly matched the broad index during the 12 months that ended December 31, 2014, and it outperformed over the trailing 5-year, 10-year, and 15-year periods. What is more, since the dividend portfolio has required the investor to assume less risk (as measured by standard deviation), it also offered superior risk-adjusted returns over these periods.

Active Traders

For active traders, on the other hand, dividends offer a unique overlay for anticipating changes in price action — days or weeks in advance. Consider the moment at which a share stops trading with dividend rights attached — a day known as the ex-dividend date.

The market price of that share will immediately fall by the precise value of the dividend. Dividend trading specialists can try to profit from that predictable price move through dividend capture strategies. (Keep in mind that direct dividend income may be treated more favorably than ordinary income when earned from shares held in a conventional taxable account. However, short-term trades designed to produce gains that are equivalent to dividend income may not qualify for favorable tax treatment.)

Dividend-related price swings may also create arbitrage potential between various financial markets where the values of cum-dividend and ex-dividend contracts might not accurately reflect the market values of the underlying securities. Active traders have created pricing models that factor the value of dividend cash flows into futures, options, and cash trade scenarios. Sometimes these analyses suggest that some markets may not appropriately reflect the value of dividend factors among all of the other components of a given trading price.

Technical Language

Investors seeking to specialize in dividend-paying stocks, should master the specific terminology of dividends:

• Dividend Rate is expressed in dollars and cents per share for a particular period — usually quarterly, semiannually, or annually.
• Dividend Yield is the annualized dividend payment divided by the current share price, expressed as a percentage.
• Dividend Declaration is the formal vote by a company’s directors to pay a particular dividend.
• Regular Dividend is the term used to denote an ongoing commitment (When a company uses the term “regular,” investors can infer a degree of constancy in the level of the dividend and the timing of the payments, keeping in mind that a dividend may be “omitted” by directors if the company’s profitability or liquidity conditions are not met).
• Special Dividend describes a cash or stock distribution made in response to a unique circumstance and implies a one-time-only distribution.
• Record Date is the last day that an investor can have his or her name recorded by the company registrar as a shareholder eligible to receive dividends (An equity trade must be fully settled by that date, not merely confirmed for settlement).
• Ex-Dividend Date (ex-date for short) is the last day that a share trades with all rights to the next announced dividend.
• Cum Dividend means that a share is traded with full dividend rights.

It is important to keep in mind that a number of market forces will shape a stock’s price at any given time. Sometimes, these forces could counteract any anticipated ex-dividend price drop. In addition, there are a number of tax considerations in addition to the reduced rate for dividend income, so traders should evaluate complex strategies for hidden tax implications.

Source/Disclaimer:

¹Source: Wealth Management Systems Inc.

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