Special Dividends Not All That Special

I'd like to address special dividends based on a question a subscriber asked me about the $10 special divided that Health Management Associates (HMA) declared a couple of weeks ago to ward off a private equity takeover. This subscriber felt that this $10 special dividend represented a good short-term profit opportunity and was wondering why the stock had not appreciated after the announcement.

HMA has actually declined more than 8% since the announcement of a special dividend because the company has taken on additional debt in order to finance the dividend. The company has decided to suspend its regular dividend indefinitely and in the process got its debt rating cut to junk status by the S&P 500. Essentially what HMA is doing is similar to you taking a big loan of $100,000 from your bank and then considering it as cash in your pocket to spend freely. Hence HMA's balance sheet is not as strong as it used to be and the stock is worth less.

Just like any other special dividend, as soon as the $10 dividend is paid out, the price of the stock will drop by $10 per share since market makers will adjust the price down by the amount of the dividend. As you can see this from the following charts, this is exactly what happened after TD Ameritrade (AMTD) paid out its $6 per share special dividend and Marcus (MCS) paid its $7 per share special dividend in 2006. If you are not familiar with Marcus, you might find my earlier blog entry interesting.

Another issue with special dividends is taxation. Special dividends are sometimes considered an "adjustment to the cost basis" and sometimes are taxed at the same rate as regular dividends, currently at a rate of 15%. Most folks holding stocks that pay these dividends in a taxable account may not be happy with this sudden tax burden. The FAQs about the Marcus dividend and the TD Ameritrade dividend should provide additional insight into how special dividends are paid out and taxed.

As an interesting side note, I should mention that according to the academic study "Special dividends and the evolution of dividend signaling", 61.7% of NYSE firms paid special dividends in the 1940s, while only 4.9% of NYSE firms paid special dividends in the first half of the 1990s. According to this study, while the stock market generally reacts favorably towards companies declaring special dividends, this positive reaction only averages about 1%. Hence it is hard to make a case for investing in companies primarily because they have declared a special dividend.

Comments

[Saul Sterman:]

Very clear and concise, thanks.

A reverse example is TOPT. In March 2006 they declared a special dividend of $7, if memory serves me, and the stock shot up by $7, only to fall again the day after ex-date. Apparently investors were/are confused about how an ex-date works (hint, hint Asif!), so the stock actually fell $2 on the ex-date! This is so unusual that until today, many data providers have erroneous charts for TOPT.

If a 2006 chart does not show a spike to $18 in March 2006, then the chart is wrong. I tried to convince Worden to correct their Telechart data… SA media provider quotemedia.com chart is correct.

I never got around to finding out what happens if you short the stock at $18 (including special dividend payment). Does the short seller have to pay the dividend? Does anyone know how this works? At the time I recall asking several brokers and none of them knew the answer! Perhaps they were all short and pocketing the proceeds – just kidding!

Typo correction – “cut to junk status by Standard & Poor’s”

Saul Sterman
CrossProfit
(The CrossProfit site is undergoing a total revamp and should be back up 2/15/07)

2007 Jan 31 05:21 PM

[Asif Suria:]

Thanks for the hint Saul. The drop is usually on the ex-dividend date and not the distribution date. However in both the special dividends discussed in this post, the ex-dividend date was the day <b>after</b&g... the distribution and hence the price adjustment happened right after the dividend was paid.

Thanks for mentioning the typo. I have fixed it on the SINLetter blog.

Regarding shorting a stock that includes a special dividend, I would think that just like any other dividend you would have to pay the dividend or the broker might adjust your cost basis. We would need someone who has done this before to comment to confirm exactly what happens. As an alternative, you could try shorting HMA and find out for yourself.

2007 Feb 01 03:48 PM

[IPAYMYTAXES:]

dividend counters margin interest paid to provide short term leverage

2007 Mar 26 02:39 AM