I Don't Understand Dividends

Includes: CLF, MUR
by: George Acs

I've never quite understood the broad allure of dividend paying stocks. While I do understand that paying a dividend is somehow a proxy for a company's financial health, there must be some better way to manifest health, like getting a nice tan. Now that the Supreme Court has decided corporations are people, there certainly has to be some kind of human metric equivalent to indicate that a company is healthy.

From what may be an extremely simplistic perspective, getting a cash dividend is a worthless endeavor, at least for the individual investor. Your share price goes down an equivalent amount and then you get taxed on the dividend. Granted, I've heard it said that the reduction in price is recovered in time. That's why companies like General Mills (NYSE:GIS) that have paid dividends for over 100 years have share prices approaching infinity (adjusted for stock splits).

The dividend paying company is put at a disadvantage and subsequent to paying a cash dividend has less money available to expand the business or make acquisitions. By extension, society suffers from the loss of potential investment in the business.

The only seeming winners are tax agencies that receive payments on dividends received as well as tax payments on the earnings that helped to generate the cash for re-distribution to investors. I suppose that the company benefits, as well, by getting some of that cash out of the system that a corporate raider might otherwise find so appealing.

What makes me truly feel like an idiot is that if you attempt to search the internet for articles that detail the disadvantages of corporate dividends, you won't come up with very many disadvantages, but there's a long list of advantages, most of which appear just touchy-feely good to me.

From a political perspective I'm further confused as it appears to me that dividends are the sort of thing that appeal to "takers" and for many stocks dividends have become an entitlement that often excuses the company from meaningful share performance.

Of course there are many who will show the very positive impact that a Dividend Re-investment Plan (NYSEARCA:DRIP) has had on their portfolio. While I do understand the basis behind the concept of a DRIP, the assumption that reinvestment will result in the sum of parts exceeding the whole works only if one assumes that the long term only brings growth. The funny thing is that is no longer a given, as many investors will sadly bemoan their lost decade in stocks. Personally, I prefer PRIP to DRIP.

But nonetheless, I look for dividend paying stocks and seek the opportunity to own as many as I can.

Today (November 19, 2012) for example, I purchased shares of Cliffs Natural Resources (NYSE:CLF). The prior week, I purchased shares of Murphy Oil (NYSE:MUR), which also went ex-dividend the day following the purchase, as well as paying an extra worthless Special Dividend.

I also no longer own Murphy Oil and I hope to not own Cliffs Natural Resources by the close of this trading week.

Yes, I'm a taker, despite the fact that I don't receive any entitlements and am in the highest tax bracket. I'm a taker as long as someone else is willing to offset some of the price reduction seen in shares when they go ex-dividend. I'd like to think of it as exploiting an inefficiency, others may see it more darkly.

But I'm also a giver.

I try to give as much of the risk of share ownership to someone else, while receiving the benefits, most notably, the dividends and the option premiums.

Being able to be part of both worlds is as much a miracle as being human by day and vampire by night, except that my world is real.

In the case of Cliffs Natural Resources, which is a far more volatile company than I most often get involved with, at mid-day it was selling for $34.71. It actually had reversed course, falling more than 3% to that level after the market took a delayed reaction to their announcement of "significant adjustments to their 2013 operating plan."

At the point that Cliffs was trading at 34.71, and the November 23, 2012 $34.50 call option was offering a premium of $0.52. The difference between the then current share price and the premium for its nearest in the money call option had been increasing from $0.09 to $0.31 as share value was falling.

How odd.

In other words, by selling an in the money call option at $34.50 and receiving a premium of $0.52, someone was betting that shares would climb to at least $35.12 by the end of the days trading, on a day that the market was up about 170 points and Cliffs was badly trailing.

I didn't mind getting paid by someone for their right to take risk. In fact, they took two separate risks. The other was that shares would be above $34.50 by contract close this shortened trading week. Not only would they feel the burden of a $0.62 drop as shares went ex-dividend, but they had an additional $0.52 of premium burden to overcome.

For my part, I would be happy to see shares close above $34.50 and say goodbye to shares, knowing there will be an untold number of other opportunities to repurchase.

The thesis behind this particular trade was that if shares were prematurely assigned in order for the option buyer to collect the dividend, the ROI for a few hours of holding would be 0.9%. Although that trailed today's S&P 500, how many other investments could you have entered today and matched the S&P 500?

But I had reasonable confidence that shares would not be assigned prematurely, unless shares spiked significantly before the market close, as detailed in "Double Dipping Dividends," as behavior of certain kinds of investors offers great predictive value.

As it would turn out, that spike never came. but shares did go a bit higher before the closing bell, finishing trading at $35.29. Shares will then open down $0.62 tomorrow morning, reflecting the dividend payment and would begin trading at $34.67, only $0.17 above the strike price. That cushion is not likely large enough to let an option buyer have a sense of security that he could hold shares overnight without putting himself at risk for a quick fall tomorrow morning.

If you've had some familiarity with trading Cliffs Natural Resources you'll know that those price moves can come upon you very unexpectedly.

Assuming assignment on Friday, the ROI for the week would be 2.7%, despite the fact that shares could have fallen 0.6% from their purchase price and still be assigned.

Of course, there's always the risk that shares will continue to fall off their own cliff and end the week below $34.50. In that case, it's simply back to the original formula of selling calls and awaiting assignment while collecting additional premiums.

But either way, despite the fact that I may, in fact, be "a taker," I will happily pay my share of taxes, without much care as to whether the "Fiscal Cliff" resolution rescues favorable treatment of dividends or not.

As long as someone else is underwriting those ex-dividends for me and I can still go out at night to prowl for more opportunities.

Disclosure: I am long CLF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.