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Myth: Big dividends are risky, and signal that a company is in trouble. Reality: the biggest dividends can be some of the safest single income opportunities in the market. We ve all heard the warnings about companies that pay out bigger than normal dividends. The average company in the S&P 500 is currently yielding just 2%. And most experts recommend avoiding any stock with a dividend of more than 7%. While it s true that big dividends can be unsustainable and mean bad news for a company, there are some notable exceptions. My Evidence: along with my research team, I ve spent the last five months on a huge research project looking at over 4,218 of the largest dividend payouts. What I discovered is shocking and could change income investing forever. That s because I ve discovered a very unusual income opportunity that drastically outperforms the market. To illustrate what I ve found, let me explain what might be the worst-case scenario for the type of dividend payout I m talking about. The 60% Dividend Payday If you re interested in gadgets, you might remember a company called Palm. It s now defunct, but in the early and mid-2000s Palm was the world leader in smart mobile devices. Remember, this was years before the Apple iphone, ipad and Android phones and tablets hit the market. At the time, Palm sold mobile phones and tablet-like devices called Personal Digital Assistants, or PDAs. Palm had the market cornered for nearly a decade with products like the Palm Pilot and similar mobile phone products. And in June 2007, it was still near the top of the heap, though Palm faced tough competition from Blackberry and later that month Apple launched the first iphone. In any event, Palm announced a huge dividend on the heels of special financing from a private equity firm. First off, the company did a lot of tap-dancing to make this private equity deal go through. And in the end, a significant chunk of the dividend was financed through debt. That s always a warning sign for any dividend, but it was especially problematic in this case. That s because this dividend amounted to $9 a share. The dividend equaled 60% of the share price, based on the declaration day price of $16 a share. That s right: Palm issued a 60% dividend, mostly funded with debt. 2
That seems crazy, since most companies pay out 2 or 4% dividends. Yet in this unique situation, Palm was paying out over half of its market cap in just one day. And it did pay out $9 a share But what happened next is the greatest fear for most investors. First, the stock dropped $9 a share on the ex-dividend date which happened to be the day after the dividend was issued. For people who never really take a close look at their dividend, this price drop always happens It s just that with most dividends, the yield is so small they don t notice the commensurate drop in stock price. (More on this price-drop phenomenon in a minute ) In Palm s case, it was such a big drop that it shocked many shareholders into dumping shares right after the payout. How do I know? Well you can look at the trading volume for PALM stock. In the days before the payout, Palm traded between 2 and 4 million shares a day. But the day after the payout (when shares dropped $9), trading volume spiked to over 13 million shares. That was the biggest volume day in months. We can t know for sure, but it seems like investors panicked and sold Palm shares for the simple reason that they saw the price drop $9 in one day. They didn t know that stocks always fall on their ex-dividend date, commensurate with the dividend payout. But the bad news didn t stop there. In September of 2007, Lehman Brothers analyst Jeff Kvaal downgraded Palm citing competitive concerns. And then things got worse. After selling for a high of $19 a share in 2007, the stock tumbled down to the mid $1 range by December 2008. Obviously the financial crisis was in full swing, and that crushed all stocks. But the timing couldn t be worse for Palm. That s because the New York Stock Exchange has listing requirements that say a company has to sell for at least $1, or it can get de-listed from the exchange. So to re-cap: Palm issued a huge dividend funded by debt Stock price dropped 60% when the dividend was paid out The company faced enormous competitive headwinds from the Blackberry, the iphone and Android devices And was on the verge of being de-listed by the NYSE 3
But then, something amazing happened Palm stock started rising and rebounded to its $16 declaration day price and then kept going. It got up to over $18 a share by November of 2009 just over 2 years after the $9 dividend payout. In other words, investors who bought Palm on or near the declaration date ended up with a 60% dividend payout and a 12% capital gain in about 28 months. That s a total gain of 72%, and an annualized gain of about 26%. Now, you probably haven t thought about Palm very much recently. And I didn t either, until I started my latest research project. But I remember these facts, because I d covered Palm as a research analyst back in 2007, and I always wondered: If this company with everything going against it can regain its pre-dividend share price how often does it happen? Is there a viable trading strategy based on collecting big dividends and capital gains? In other words, can we have our cake (giant dividends) and eat it too (have the stock rebound to its pre-dividend price)? As I mentioned, I dug into over 4,218 of the largest dividend payouts going to back to the early 1990s. But before I did this research, I looked everywhere to see if anyone else had done this kind of digging. I was shocked to find that there really isn t any research of this kind that seeks to answer this specific question. No one has looked at big dividends and near-term stock performance. No one has tracked how these companies perform after big payouts until now. And this research was time consuming to say the least. But this research has convinced me that in some (not all) circumstances, buying companies ahead of a large dividend payout can be one of the safest ways to collect income and capture capital gains. This research probably seems outrageous, because the theme we always hear is that big dividends or big gains generally come with big risks. But these large payouts are not the result of excessive risk or leverage they re usually the result of an unexpected windfall for the company. 4
The basis for paying out a giant dividend basically comes down to a situation where a company has a huge amount of cash and no good way to spend it. A large influx of cash could come from almost any source. It could be from a big lawsuit victory. It could come from selling a division of the company or of real estate assets. If could be the result of repatriating assets being held overseas. Or it could be the result of huge, blow-out earnings. These events are all good news and signal a healthy company that s gushing cash. And passing on cash to shareholders is about as shareholder friendly as it gets. That s almost always a good sign. So why does the price drop? Remember the price-drop phenomena I mentioned earlier? It s important to understand why the stock drops in price on the ex-dividend date because I believe this drop is the key to why this strategy is profitable and it s also why many investors blow their chance at making money from these large payout events. This is the single most important key to why this dividend strategy works In short, stock exchange market makers drop the price commensurate with the per share dividend payout. Now, at first glance it makes sense. If a $10 stock pays out a $1 dividend how do you account for $1 per share leaving the company s books? The simplest and most straightforward way is to drop the price of the stock $1 on the ex-dividend date. Exchanges drop the price so that people don t just buy the stock the day before ex-dividend, then collect it and sell the next day. I understand why But for an example of why this price drop is imperfect at best and a great buying opportunity think about a company like Berkshire Hathaway. For one, Berkshire has never paid a dividend, and likely never will. But Berkshire is a cashproducing machine. Every MONTH Berkshire brings in about $1.5 billion in cash from its various subsidiaries and stock holdings. If Berkshire s stock price truly reflected its cash holdings, then from one month to the next, you might expect it to sell for about $1.5 billion more. Or at the very least, you might expect it to be valued at about $18 billion more after 12 months. But of course, that s not what happens. 5
Berkshire has about $18 billion more than it did this time last year. And yet it s stock is selling for about 2% less than it was a year ago. So, there s no rhyme or reason that strictly ties cash holdings of a company to its share price. We can see this phenomenon all the time when companies make other cash transactions, like an employee bonus payout, or a real estate transaction, or an acquisition. All of these cash transactions result in one-time cash deductions that may or may not materially affect the company and which certainly don t directly impact the stock price. When it comes to a one-day dividend payout, the market makers on the NYSE and NASDAQ exchanges drop the price. I understand why. Cash in the bank is obviously important, but I don t think very many investors would say that a $1 per share cash transaction has an equal and opposite effect on the stock price. A company is much, much more than just the cash it has in the bank. There are obviously other tangible assets like real estate, equipment and other property, but things like brand and market penetration and growth are very intangible, and arguably more important than cash on the balance sheet. Ask Coca Cola or Nike if they d rather lose all of their cash or their brand name, and I think you ll have an idea of what I mean. 6
The Catch So these big payouts offer us a unique opportunity to profit from a real asymmetry in the market. They happen more often than you might think: according to my research, about an average of 15 large dividends get paid out each month. Even better: there s good reason to believe that companies may start to accelerate these payouts. But the catch is: in order to capture the bulk of the gains, you have to be prepared to act quickly on a dividend announcement. My research shows that the biggest gains come on the day the company declares the dividend. After that, the market seems to bid the stock price up, which lowers the dividend yield. There are circumstances where you wouldn t want to collect the dividend! I mentioned the Palm example, and even though it worked out, it was a long shot mostly because the dividend was funded by debt, instead of a cash windfall. But the good news is: As a member of Income and Prosperity: Dividend Alerts, I will send you updates on upcoming large dividends as they get announced. The important thing is to be attentive to these emails. I will be sending them out as I find new information about these large payouts. Plus, I ll continue to share more of my research findings from this groundbreaking project. Keep an eye out for about an email or two every week and be ready to act when the time is right. Good investing, Steve Mauzy Contributing Editor 7
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