The title of the article probably makes little sense at first glance: "I like money, but I hate getting paid" comes to mind. Yet, dividends present an interesting paradox. While investors appreciate firm's management intention to pay out profits, getting the actual money is less exciting. The dividend is immediately taxed in a taxable account, or, even worse, a large part of the dividend is withheld when a company is foreign. The dividend payment itself doesn't create any value: whatever you gain in cash, you lose in the stock value.
Why pay dividends?
A company hoarding a large chunk of cash on its balance sheet hurts its profitability. Most common valuation metrics such as Return On Assets, Return on Equity, P/E, or P/Free Cash Flow are negatively affected by the extra cash since it's a non-earning asset. Once a company "disgorges" unused cash to its shareholders, all its capital is invested in making money.
There are two main ways a firm can return uninvested cash to its shareholders: dividend payment and stock buy-back. Stock buy-backs sometimes work best for larger liquid companies (a company may drive its own stock price while buying illiquid shares), while dividends work well for firms of all sizes.
A lot of small cap companies with a lot of unused cash suffer from governance issues. The management may start paying insiders lavish compensation, make an ill-conceived acquisition, or buy a corporate jet.
Therefore, it's heart-warming to see a company parting with all its extra hard-earned cash every year as a matter of official dividend policy. MIND C.T.I (MNDO), an Israeli software company that serves telecom industry, pays out all its current earnings (EBITDA - taxes) once a year. MNDO paid out 10.81%, 9.41%, 9.76% dividend yields in 2010, 2011, and 2012. All payments are usually made in March after it announces its fiscal year results. A tiny (35 million market cap) but stable company with a high dividend has become very attractive to many retail inverts looking for good dividend stocks in a zero interest rate environment.
Unfortunately, MNDO dividend comes with a big catch. Since the company is Israeli-based, 25% of its dividend is withheld by Israeli tax authorities. The tax treaty between the US and Israel only ensures that a US investor doesn't get taxed twice - he is "forgiven" a 15% US dividend tax after paying 25%.
A case study of incredible investor ignorance
Having followed MNDO for a couple of years, I've become thoroughly convinced that many of its investors do not understand how dividends work at all. A dividend payment is a zero-sum game where the price of a stock you hold is precisely reduced by the dividend amount. I have seen a number of postings on Yahoo message board by investors patiently waiting until a few days before the ex-dividend date to buy a stock, only to dump it several days later after the payout is recorded. To explain why this is such a bad deal, let's look at MNDO's last payout:
MNDO closed at $2.46 on 03/09, a day before its 03/12 ex-Dividend date. Anyone who bought a share on this day got ($0.24 - 25%) = $0.18 dividend. The price was reduced next day (ex-Dividend) by $0.24. If an investor bought this stock on 03/09 and sold on 03/12, he immediately lost $0.06 per share (2.4%!), assuming everything else being equal and not counting transaction costs.
If you think that this may be one clueless poster, who makes a yearly donation to the Israeli tax authorities, think again after looking at this chart:
D - is an ex-dividend date, all prices are fully adjusted for a dividend payment (the dividend is deducted from the time series), and the Russell 2000 index is "normalized" to show the market movement:
You can see that MNDO significantly outperformed the small cap market in the last 10 days in a run-up to its ex-dividend date, only to collapse in the next day or two after the dividend was recorded.
Of course, this chart may be just a mere coincidence. After all, stocks go up and down for all kinds of reasons.
Apparently not so in this case:
The picture remains the same during the last three years: MNDO outperforms the market in a run up to the dividend payment, only to fall shortly afterwards!
I wasn't satisfied with just three "coincidences". After all, in 2011, MNDO went up the day after ex-Div. day (though less than the market) before falling.
I ran a correlation analysis from 2007 that included the last 6 dividends (MNDO paid one extra, special dividend in 2009).
MNDO has a 20.49% daily correlation with Russell 2000 between 03/01/2007 and today. Shockingly, it had only 0.79% correlation when I created a time-series that includes ten days before ex-Dividend date and two days after for last five years. Every single time, the stock outperformed, leading up to ex-Dividend date, and underperformed the next two days. (I apologize to statistics purists who will eagerly point out that my second correlation is "less statistically significant").
I'm happily adding to my position right AFTER the dividend payment!