1/12/2013 Introduction to. Dividend Capture. By Joseph Soh, Research Analyst. NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE

Size: px

Start display at page:

Download "1/12/2013 Introduction to. Dividend Capture. By Joseph Soh, Research Analyst. NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE"

Derek McKenzie
6 years ago
Views:

1 1/12/2013 Introduction to Dividend Capture By Joseph Soh, Research Analyst NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE

2 Introduction to Dividend Capture When investing in equity markets, returns on investment come in two main forms: realising of capital gains on stock prices, and receiving of dividends from holding dividend-paying stocks. Capital gains are realised when the market price of a stock has appreciated in respect to its purchase price, and the stock is sold at that higher price for a profit. Dividends are essentially payments made by a corporation from a portion of its profits or retained earnings to its shareholders. Also known as distributions, dividends can be paid out to shareholders in the forms of cash, stock or property. In this article, we will focus only on cash dividends for simplicity s sake. How are dividends usually earned? Generally in dividend investing, a good investor will first look out for a high dividend yield, i.e. the stocks annual dividends per share is a higher percentage of its share price as compared across the markets, sectors, and industries. Secondly, dividend investors will also favor stocks with high dividend coverage, which means the company s earnings are several times that of their dividend payout. High dividend coverage indicates safety and sustainability of the dividend, even in less profitable periods for the company. The nature of dividend investing is inherently longer term, having lower risks and returns, and provides a more stable source of income than investing in the capital gains of stocks. However, it is also possible to quickly capture the dividend issued by a company through a more unconventional, shorter term investment strategy known as the dividend capture. But before this article explores the dividend capture strategy, it is important to be familiar with the following dates. Important dates to take note Declaration date: In-dividend date: Ex-dividend date: Record date: Payment date: Board of directors announces its intention to distribute a dividend It is the last day when existing holders of the stock will be entitled to dividends; any holders who sell their stock will give up their right to the dividends to the buyer. In-dividend date is one trading day before exdividend date. All stocks bought and sold on or after this day will no longer come with the right to receive dividends. The loss of this right will automatically be priced into the stock in an efficient market. Ex-dividend date is typically two trading days before record date. Stockholders on record at this date will receive the dividend. In most countries including Singapore, stockholders who purchased shares before the ex-dividend date will automatically be on record. Dividends from a company will be mailed as cheques to its stockholders or credited into brokerage accounts or stockholders bank accounts. Refer to diagram on the next page for pictorial timeline representation

3 In-dividend date not shown in the above (Picture courtesy of What is dividend capture? In contrast to the more common dividend investment strategies that require holding onto a stable dividend paying stock over a long duration for a stable stream of income, dividend captures are usually executed with a much shorter term time horizon. In fact, the targeted stock is sometimes held for only one trading day. Simply put, the dividend capture strategy is the purchase of shares prior to the ex-dividend date, followed by selling off their shares afterwards. The expected dividend payment is reflected in the share price before the ex-date. But after the ex-date, buyers of the shares are no longer able to receive the company s dividend, and as stated earlier, the loss of dividends should in theory decrease the share price by the exact price of the dividend amount. In reality, the markets are not completely efficient, and this does not always happen. As such, shares are then sold immediately on the ex-date before the price falls, or when the share price returns to its former purchase value, depending on the price movements. An example on dividend capture Let s say the stock of a hypothetical ZZZ company is trading at a market price of $10.00 before the ex-date and the stockholders are entitled to an upcoming quarterly dividend of $0.50. In an efficient market, the price of ZZZ stock should drop exactly to $9.50 as those investors only buying the shares then are unable to receive the $0.50 distribution. Basically, an investor can purchase ZZZ s stock for $10.00, hold it for one trading day and sell it on the ex-date for $9.50 and still receive dividends on the payment date. The potential to generate quick access returns results from the possible phenomenon whereby the stock fails to fall to $9.50 as theory would suggest. And also, even when the expected fall does occur, the stocks recoup their value shortly thereafter. The advantages There are numerous companies on the stock market that pay their dividends at varying times of the year; dividends on the whole are being distributed by different companies on a weekly basis. Hence, a large holding in one company s shares can be rolled over regularly into new positions in other companies, capturing their dividends with each change in position. Starting with a sizable initial capital investment, users of dividend capture can take advantage of the short time horizon of this strategy to frequently compound returns from successful execution of the above steps. It is often best to focus on mid to high dividend yield (>3%) corporations with large market cap. This is to

4 minimise the risks associated with smaller, less stable companies while still realising a significant return. Another thing that makes this strategy attractive is that it requires little to no fundamental analysis to carry out. The disadvantages In every trade executed, there are transaction costs incurred. This is no different for the dividend capture strategy. As dividends is usually a small percentage of the stock price, the cost of transaction amounts to a noticeable portion of the returns. Furthermore, the retraction of the stock must also be taken into account. Using the example of ZZZ company, if their share price falls to $9.60 instead of $9.50 on the ex-date, the net yield of the dividend capture would only be $0.10. Assuming an investor has used $10,000 to buy 1000 shares of ZZZ prior to the ex-date, his return will be $100, or 1% of his investment. However, his returns will be further reduced when we deduct the cost of transaction. To illustrate this, we can take the transaction charges of an online stock trading platform in Singapore. POEMS (Phillip s Online Electronic Mart System), for instance, charges a minimum of $25 for every transaction, 0.28% for any transaction up to S$50,000, 0.22% for transactions between S$50,000 to S$100,000, and 0.18% for transactions upwards of S$100,000. To carry out the aforementioned dividend capture, 2 S$10, % = $56 will be incurred. The dividend capture strategy only yields $44 in total. This excludes access fees to bourses, dividend charges and dividend taxes (if any, dividends are not income taxable for Singapore tax residences) which will once again lower the gain from this strategy. A large number of stocks must be traded to bring considerable profits on top of covering such fees. The full potential of the dividend capture strategy can only be capitalised through large positions, which brings about its own associated risks. As mentioned, potential returns from a pure dividend capture strategy are commonly small while possible losses can be substantial if a negative market movement occurs within the short holding period. Such adverse movements can swiftly eliminate any potential returns of the dividend capture. In the event that the share price falls greater than the amount of dividend paid out per share, the investor may be forced to maintain his position for an extended time period for the share to fluctuate to his purchase price. This exposes the strategy to greater systematic and company specific risk, which are undoubtedly present in all trading or investing strategies. As stated in the advantages, the dividend capture strategy should adopt a similar focus as dividend investing, which is on highdividend paying, large blue chip companies to minimise such risks. Capturing dividends with options The stock option is a tool that can be employed by users of the dividend capture strategy. There are two main types of options: the call option, which allows the investor to buy stocks at a particular price (strike price) within a certain time period (up to the expiration date); and the put option, which allows the investor to sell stocks at the strike price before and up till the expiry.

5 As shown in the previous calculations and examples, an investor s earnings from the captured dividends might possibly be nullified by the retraction of share price, brokerage fees and other fees. However, one can capture dividends more effectively through options. Just prior to the ex-dividend date, an investor can do a covered write call by buying stocks of the dividend paying corporation, and concurrently write an equivalent quantity of deep in-the-money call options (strike price of call option significantly below market price of the underlying stock) on the stocks. The call strike price plus option premiums received should add up to or be greater than the current stock price. Assuming the call option is not assigned on ex-date, the investor who wrote the call would have qualified for the dividend as he still possesses the underlying stock. Following the ex-date, the underlying stock price is expected to drop, with the written call options falling by the same amount (deep in-the-money calls have delta of almost 1). The underlying shares can then be sold and the short calls bought back at no loss, all while eligible to receive dividends. Example on dividend capture using options Once again, using ZZZ company as an example, the ex-dividend date is declared to be on 1 Nov. On the in-dividend date, ZZZ s shares are trading at $10 per share while a Nov 7 call option (strike price of $7) is priced at $3.05. An investor buys 1000 shares of ZZZ (total $10,000) while simultaneously writing a Nov 7 ZZZ covered call for $3050. On the ex-date, the share price of ZZZ drops by $0.50 to $9.50, while the Nov 7 ZZZ call would likewise drop to $2.55. As the said investor is already registered in the stockholders on record and thus qualified for the payout, he could exit his position by selling his long position of ZZZ for $9,500 at a loss of $500 and buying back the short position of the call options for $2550 with a gain of $500. The gain and loss of the two transactions negates each other, and the return on this trade is the $500 dividend less relevant fees and taxes. However, the risk to take note of is that early assignment could possibly occur before the ex-date, resulting in the options writer unable to collect the dividends. To mitigate this risk, the investor should ensure that the premiums received from selling the call options will be able to cover the transaction fees involved in this strategy. Takeaway Dividend capture provides an alternative, unconventional method to investors seeking income. Advocates of the efficient-market hypothesis maintain that that the supposedly risk-free profit of capturing dividends will be reduced and ultimately negated by the pricing in of dividends into the stock price, market fluctuations, early assignments of call options, and brokerage fees/charges. Nevertheless, this strategy has been effectively used to generate quick returns by best in class fund managers. There are risks and opportunity costs associated with every single transaction. Therefore, it is always vital to perform analyses of any chosen stock, even in the intended short time horizon of dividend capture. Most importantly, one must feel comfortable executing their investment strategy with the available investment vehicles.

6 research@nusinvest.com if you have any questions! We will do our best to answer your queries! This research material has been prepared by NUS Invest. NUS Invest specifically prohibits the redistribution of this material in whole or in part without the written permission of NUS Invest. The research officer(s) primarily responsible for the content of this research material, in whole or in part, certifies that their views are accurately expressed and they will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this research material. Whilst we have taken all reasonable care to ensure that the information contained in this publication is not untrue or misleading at the time of publication, we cannot guarantee its accuracy or completeness, and you should not act on it without first independently verifying its contents. Any opinion or estimate contained in this report is subject to change without notice. We have not given any consideration to and we have not made any investigation of the investment objectives, financial situation or particular needs of the recipient or any class of persons, and accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the recipient or any class of persons acting on such information or opinion or estimate. You may wish to seek advice from a financial adviser regarding the suitability of the securities mentioned herein, taking into consideration your investment objectives, financial situation or particular needs, before making a commitment to invest in the securities. This report is published solely for information purposes, it does not constitute an advertisement and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein. The research material should not be regarded by recipients as a substitute for the exercise of their own judgement. Any opinions expressed in this research material are subject to change without notice NUS Invest

By Tri, Senior Analyst

1/1/2014 Trend Following By Tri, Senior Analyst NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE Introduction Trend following was introduced by Richard Dennis when he taught trading strategies