The Insanity Of The Chase For Special Dividends

Includes: MPWR, NSP, TLAB
by: Vince Martin

Teligent figures to gain ground after it posted a smaller-than-expected loss in its fourth quarter Monday, losing $156.6 million, or $2.89 a share, on sales of $15.5 million...For the year, Teligent lost $531.8 million, or $9.95 a share, on sales of $31.3 million...Thirteen of the 15 analysts tracking the stock maintain either a "buy" or "strong buy" recommendation. First Call consensus expects it to lose $11.30 per share in fiscal 2000.

-- "Stocks To Watch,", March 7, 2000

I saw the insanity of the dot-com bubble first-hand; the broker who sat across for me, in fact, pitched Teligent stock for months, excitedly watching it climb to over $100 per share, giving the company a market capitalization of $6 billion. Of course, the bubble would burst; 15 months later, Teligent was bankrupt.

Twelve years later, with the Fed's ZIRP firmly in place and bond yields at an all-time low, I've seen faint echoes of 2000 in investors' headlong rush into yield. Whether it's investors paying massive premiums for yields that mostly include "return of capital," or the casual promotion of options strategies to create "low-risk" income, there is a clear herd mentality in the dangerous, albeit understandable, thirst for any type of yield.

Nothing has illustrated the dangers of that thirst, and nothing has so reminded me of the market-wide insanity seen in late 1999 and early 2000, as the recent share gains seen by companies paying special dividends. A host of companies, driven by potential tax changes in 2013 due to the so-called "fiscal cliff," have made special distributions over the past few weeks. These decisions are hardly surprising, and, from a shareholder perspective, perfectly rational; it makes no sense for a company to keep unneeded cash on the books earning (at best) 1 percent return when a timely return could decrease a shareholder's dividend tax burden by as much as 28 percent of the distribution.

Nor it is surprising that companies who have announced special dividends have seen a rise in share price. Theoretically, if a company were to pay out, for example, 10 percent of its market capitalization in cash, that cash has more value in the pockets of its shareholders at a 15 percent tax rate than it would being on the books in 2013, subject to a dividend tax that could be substantially higher. For companies with a large cash balance, there is also an understandable boost, as a distribution mitigates a common risk with cash-heavy companies: that management will squander the cash through an ill-timed investment or a poorly-executed acquisition.

But what has been absolutely stunning is the magnitude of gains made by companies that have made special dividends. Here's just a small sample:

  • Almost Family (NASDAQ:AFAM), a small-cap home health care provider, jumped 7.2% after announcing a $2 per share special dividend.
  • Retailer Cato Corporation (NYSE:CATO) rose 3.2% after announcing both a special dividend and the acceleration of 2013 payments; any investor chasing the dividend was hammered on the ex-dividend date Wednesday, as the stock fell over 4% in addition to the $2.25 per share drop in dividend payments.
  • Monolithic Power Systems (NASDAQ:MPWR) jumped 4.3% on Tuesday after announcing a $1 per share special dividend; the stock rose 91 cents, accounting for nearly the entire dividend payment.
  • Staffing company Insperity (NYSE:NSP) rose by $1.70 per share, or 6%, after announcing a $1 per share dividend and a $50 million modified Dutch auction tender offer for its own stock, representing 7% of shares outstanding. The stock has already exceeded its ex-dividend price, and is at a five-year high.
  • Another staffing company, micro-cap RCM Technologies (NASDAQ:RCMT), range-bound for nearly all of 2012, jumped 11% after a $1 per share distribution representing about 18% of its market capitalization.
  • Semiconductor maker Supertex (NASDAQ:SUPX) rose 6.9% after a -- you guessed it -- $1 per share special dividend. This despite the fact that the company has over 80% of its market capitalization in cash -- over $13 per share -- and that the announcement coincided with negative revenue guidance for the coming quarter.
  • Perhaps most stunningly, struggling telecom equipment maker Tellabs (NASDAQ:TLAB) jumped 21 -- twenty-one -- percent after its $1 per share distribution was announced. (The company did also name a new CEO, but the company's choice had already been acting CEO and it seems unlikely that decision moved the market.)

The fact that these stocks moved by 6, 11, and, in Tellabs' case, over 20 percent is simply not justified by what is essentially a transfer of custody of a (relatively) small amount of cash. Ownership is not changing; a shareholder already owns the assets of a company. What is changing is who directs the use of the cash being distributed. For that minor change to create these substantial rises in share price means that either a) management is so incompetent that shareholders fear they will throw the company's cash out the window of a moving truck or b) the market is responding incorrectly to these moves.

In addition, there are also negative tax considerations to these moves. Even if dividend rates do go up, there is a benefit to leaving cash on the company's books (if management can be trusted), as those assets are tax-deferred. Yes, it seems likely that the dividend tax rate will go up in the future; but, at the same, a larger tax bill will come due in about four months. A company that accelerates a dividend payment, moving it from January to December, is making a simply, and likely logical, move; for shareholders in a company like Costco (NASDAQ:COST), who is borrowing to fund its $3 billion special dividend, the tap-dancing around the fiscal cliff may wind up being too smart by half.

The irony of the recent dividend surge is that many pro-dividend investors have argued repeatedly that higher tax rates won't dent returns in dividend stocks anyway. After all, many dividend stocks are already held in tax-protected accounts such as IRAs; dividend stocks performed just fine after the last tax rate hike, in 1993; and the taxes only hit the rich anyhow. If that's true, why the rush into special and accelerated dividends lately? Either tax policy affects the value of dividends, or it doesn't. Right now, too many dividend advocates are trying to have it both ways.

Part of the problem is there are simply too many individual investors who literally do not understand how a dividend works. (This may be why small- and micro-caps have seen bigger jumps then larger companies who have issued similar payouts: because retail investors have the ability to create larger moves in thinly traded stocks.) There are comments on this site (and elsewhere) and emails in my inbox from investors who do not understand that a dividend is just a return of capital, and that (theoretically) the share price will give back the dividend payment on the ex-dividend date. Again, a dividend does not represent a transfer of ownership; it represents a transfer of custody. There are no profits to be made from a dividend in and of itself. A dividend is not free money; it is not excess money; it is your money, simply being moved to a different account.

In short, investors need to ignore the rush of special dividends. Aggressive traders can look to short some of the names that have seen the largest jumps, believing that the market will adjust once the ex-date hits and dividend capture traders and the like exit their positions. Tellabs, at its current levels, seems like an excellent short-term trade on the short side. Here's the first reason:

TLAB weekly chart
(Click to enlarge)

chart courtesy

Tellabs has been tanking for a long time; it has lost money in each of the last eight quarters, and looks like a classic value trap. The company still has a reasonably strong balance sheet -- excluding the dividend, net cash would represent about $1.56 per share versus a share price of $2.32 -- but revenues have been falling for the last few years, as have margins. On the Q3 conference call, analyst Mark Sue noted that revenue would soon be at half its 2007 levels.

Indeed, Tellabs stock had hit a 19-year low in November, a week before a stock repurchase potentially representing 24 percent of outstanding shares was announced. A week later, the company added on the special dividend, and shares have risen 23 percent off the lows.

But there's no real reason for the rise; the repurchase agreement will, like the dividend, eat away at the company's cash balance, largely neutralizing the long-term effects. Simple common sense should dictate that a stock rise of 23% -- two years' worth of decent returns -- needs a catalyst beyond simple financial engineering. Tellabs does not appear to have any such catalyst for growth, and the stock could easily resume its slide once the dividend is paid and the repurchase announcement forgotten.

There are likely other short opportunities for similar stocks boosted by dividend announcements. Certainly Monolithic Power, trading near a two-year high, is worth a look for short-biased traders. The stock trades at nearly 20 times its trailing non-GAAP earnings even when backing out its net cash, a very high multiple in the semiconductor industry. Insperity was a stock on my watch list, but its recent run likely knocked it out of value territory, and may have created a short-term entry-point for risk-tolerant traders.

Many other opportunities likely exist, because the share gains created by the dividend opportunities cannot be sustained on their own. Once the hype dies down, the calendar turns to January, and the traders move on, the market will return to fundamentals. Many of the stocks that have gained from special distributions will likely pull back once that happens, because dividends don't change the fundamentals. It seems that, as of late, too many investors have failed to understand that simple truth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.