Beware the pitfalls of dividend stripping
Every six months the results season comes around, and August and September is the time to maximise those relatively huge Australian dividend payouts. The average yield on the ASX is around 4.2 per cent, plus franking, though it's only 2.9 per cent in resources and 5.49 per cent in the banks.
On current forecasts, 70 stocks in the top 200 yield more than 6 per cent, including franking. So there's plenty of "income" out there for those now faced with term deposit returns close to zero once you take off inflation.
A lot of you probably know all about dividend stripping and you will all have had a variety of success or otherwise with it. The traditional strip is to buy big income stocks coming up to results in the hope other buyers do the same thing. Others will tell you it is a broker's ruse to get you switching between banks at results time and that after costs it will never pay. So let me give you a few pointers.
The basic principle of dividend stripping is to buy a stock before it's ex-dividend date and sell it after it goes ex-dividend. The hope is to pick up the dividend, the imputation credit and a capital gain at the same time, or at least a capital loss that is smaller than the dividend gain (and you use the capital loss to offset gains elsewhere). Unfortunately, some stocks drop a lot more than the dividend.
In stocks that are not reliable payers but have a big one-off dividend, the post-dividend fall tends to be more pronounced as the people who "only" bought for the dividend exit again. So when it goes ex, there are no natural buyers to support the stock and you lose more than you gain. There is a rule of thumb in the sharemarket that will save you from targeting big one-off dividends, and it is this: "If a stock yields 10 per cent, the likelihood is it doesn't".
To make the whole process a bit clearer, here is an example of a perfect dividend strip and the nightmare dividend strip:
The perfect strip You buy a bank share 46 days before the ex date (to satisfy the 45-day rule). Stocks with big dividend pay-outs often run up in price ahead of the ex-dividend date. Traditionally the banks, for instance, will run a month ahead of their results and in a "safe income-focused" market as we have now, the interest is even greater.
We've certainly seen that with the CBA and Telstra. They were both close to multiyear highs ahead of going ex-dividend last Monday, so much so that the research is now shouting "overvalued". So you buy a quality income stock and it rallies into the results. The stock has results. They are good and the share price rises again. The stock goes ex-dividend. The share price carries the dividend and closes up that day. You sell with a capital gain, entitlement to the imputation credit, and you get a cheque for the dividend, plus franking. Your broker rings you to say how much he loves you for churning bank stocks.
The nightmare strip You read a bit of research about a mining-services company that has a consensus forecast yield of 13.5 per cent and it is fully franked. Results are coming up, so you decide to buy early to get a head start on the 45-day rule. The stock falls ahead of results. The results are terrible and the dividend is cut. But it is still a big dividend yield so you hold on for the "ex date".
The stock slides into the ex-dividend date. Once it goes ex 10¢, the share price opens down 14¢ (the dividend plus the franking) and sellers beat you to it and it falls 20¢. It then continues to trend down in a very illiquid market. You start asking questions. Seems you failed to notice the stock was in downtrend after a profits warning a month before you bought in. The reason the stock had a 13.5 per cent yield was because the share price had fallen and the consensus yield was based on a pre-profit warning consensus dividend forecast that was out of date. Finally you bite the bullet and sell it.
It immediately bounces.
● Taking consensus forecasts for granted.
● Buying a stock simply because it had a big yield.
● Buying a stock in downtrend.
The moral? Never buy a rubbish stock for any reason.
The bottom line is that there is nothing for nothing. Buy a stock just to collect a large dividend without putting a stock through all the usual investigations and you are doomed to fail. To succeed at dividend stripping you really need to be buying quality stocks you are happy to hold, that are trending up, in a rising market, that just happen to be going ex-dividend as well.
Marcus Padley is a stockbroker and the author of stock market newsletter Marcus Today. For a free trial go to marcustoday.com.au.