Dividend Stock Behavior and the Comatose Investor

by: MyHappyTrading

Dividend-paying stocks have a reputation of being slow, dull, and stodgy stocks, not particularly exciting prey for the active investor. After all, these are the stocks you just sit back and watch, collecting your check in the mail, right? No reason to buy and sell them at all, just buy and hold forever? Not necessarily. There is a lot of opportunity in dividend stocks to pursue returns, perhaps more than you might realize. I have worked with these stocks a lot, and have often thought to myself, "Someday I'm going to write all this down...". So, beginning today is a series of short articles discussing what I've learned about dividend stocks, how they REALLY work, and an examination of the basic strategies, of which "buy and hold" is only one - and sometimes, the LEAST profitable.

Let's start by quickly running through the basics. A "dividend" or "distribution" (the terms are effectively interchangeable, though they have differing accounting origins) is a bonus sent to the stockholder "of record" (the name of the person owning the account holding the stock) by the board of directors of a company. Note first that I said "bonus" - it is generally one or more of the following 4 things: it can be cash, or more of the same stock as the stockholder already owns, or some stock of a 2nd company (owned by the first company, usually), or rights to do something now or in the future. I'm going to draw a line in the sand and declare the non-cash dividends to be off-topic for the time being. This is not a handicap, since non-cash dividends are often a sign the company is running low on cash, and is looking around for a substitute. You probably would want to stay away from such a company, and let the specialists take over arbitraging these kinds of assets.

Trading aggressively means buying and selling often. As with all stocks, determining when to buy or sell is the key, and the nature of dividend stocks is that the existence of a dividend affects the price behavior. The important factors are (1) The amount of the dividend, (2) the payment schedule, usually quarterly but sometimes otherwise, (3) the dividend trend: increasing, static, or decreasing. For the moment, let's disregard the dividend trend and look at the effects of the amount and the payment schedule.

Here's Annaly Capital Management (NYSE:NLY), a dividend paying company which buys up income-producing real estate securities. They pay 68 cents per quarter. Notice how each dividend payment causes the stock to open lower on the day the dividend was paid. Theoretically, the stock should drop in value the exact amount of the dividend payment, in this case 68 cents. A good way to observe this is to connect the opening prices for two successive dividend days with a box as shown. For NLY, the drop was about .70 one day and .75 the other. You can also visualize it this way: buying a share of stock before the ex-dividend date means you are also buying the 68 cent dividend; after that date, the dividend is gone, so the stock is worth less.

Now, let's look at the theoretical behavior of NLY. On 6/24, an investor would look at the chart of NLY and anticipate the drop in price of about 68 cents. If no other factors were in play, from that date onward NLY could be expected to rise in price, reflecting the accumulation of benefit from the upcoming dividend payment. (Thick line.) At all times the investor is aware of the yield of NLY: the total of payments divided by the price. NLY is a high yield stock, over 15%. NLY and other high dividend stocks are often yield-bound, that is, their price remains bounded high and low more by yield than stock price. Unfortunately, typical stock charting applications do not automatically create lines of constant yield, or normal price appreciation lines, so we are forced to do so graphically. (Note to programmers - write a package which does this and you likely can sell it to a brokerage.)

Comparing the ideal behavior of NLY to its actual behavior shows that the stock was changing in price quite a lot during the period between dividends. Make no mistake about it - dividend stocks have risk like any stock. The dividend pays you for the risk of putting your money into the stock. However, NLY recovered to stay generally within its 15%-16% yield bounds. It is the nature of a dividend stock that its yield protects it from some of the price volatility of other stocks.

This leads us to the first strategy for dividend stocks, the standard one of buy-and-hold. Since an individual stock cannot be trusted to follow its ideal price curve between dividends, averaging by diversification is the only choice. Buy a group of different stocks, preferably in differing sectors, all paying a high dividend, and hold them. The dividends become an income stream, and the yield-binding and diversification protects you from volatility in your capital. Sounds good, right? Indeed, it is good, and this is the strategy of many investors who seek the highest income from a pool of capital which must be preserved. The key property of this strategy is that no trading is needed. This is the "comatose investor portfolio" - the ideal portfolio for the investor who might lapse into a coma at any time and could not trade their account. Awakening ten years in the future is no problem if you have the coma portfolio! With careful selection of stocks yielding between about 5 and 15 percent, an investor can put together a portfolio which beats bank 3% CD yields by a big margin, with risk considerably less than growth stocks.

Because dividend stocks are yield-bound, safety is more often equated with dividend stability or dividend growth. In financial circles, the term "dividend achievers" refers to a company which has paid consistent or increasing dividends - specifically to a list of such dividend stocks maintained by the data firm Mergent. And of course, there are ETFs based on holding securities on the Mergent list, to make your job easier:

  • BDT BlackRock Strategic Dividend Achievers Trust $9.89 Div=6.62% [FBGYQMNZSRW]
  • BDV BlackRock Dividend Achievers Trust $9.72 Div=6.74% [FBGYQMNZSRW]
  • PEY PowerShares HighYield Dividend Achievers $8.60 Div=4.26% [FBGYQMNZSRW]
  • PFM PowerShares Dividend Achievers $13.57 Div=1.93% [FBGYQMNZSRW]
  • PID PowerShares Intl Dividend Achievers $15.32 Div=2.96% [FBGYQMNZSRW]
  • VIG Vanguard Dividend Appreciation ETF $50.19 Div=1.98% [FBGYQMNZSRW]

You may ask, what does the "coma portfolio" have to do with aggressive dividend trading? Because it is the safest starting point for all dividend trading. Aggressive trading is based on opportunism, and one opportunity you will want to have open at all times is the ability to do nothing, to "play dead", and let the passage of time balance your account. Once you have a fall-back position well in mind, you can take carefully considered chances in your trading. Next week, I'll discuss the process of dividend capture and we will leave our initial comatose portfolio behind, but never quite forgotten. Let the sleeper awake.

Disclosure: No positions