Why Q4 Could Be Quite "Special" For Stocks: Positioning Your Portfolio

by: Alan Brochstein, CFA

I recently shared my views regarding how the investing landscape might change once Obama is likely reelected. When I posted my ideas, Intrade was suggesting the odds of reelection were 57%, but the odds have surged to 78%.

While I made a lot of points, I have to admit to missing a big one: special dividends. Current taxation for dividends is quite favorable, with qualified dividends taxed at 0-15% currently (0 for tax-rates of 15% or below). While it's difficult to project exactly how things play out, in a worst-case scenario, dividends will be taxed at the ordinary income tax rates, suggesting that those levels will rise. Additionally, ordinary income tax rates are going to rise for the wealthiest. The bottom line: Dividends will be taxed from 15-39.6%.

The reelection of Obama suggests a higher likelihood that dividend tax rates will rise. But don't take my word for it. Masimo (NASDAQ:MASI) CEO Joe Kiani said as much at their recent Investor Day. As I shared when I profiled the company, Kiani said that they would likely do a special dividend if Obama is reelected. American Eagle (NYSE:AEO) recently declared one, distributing $1.50 per share or almost half their cash. DSW (NYSE:DSW) too just declared a $2 special dividend. Sycamore Networks (NASDAQ:SCMR) just declared a massive $10 special dividend, representing about 2/3 of the value of the company.

For those not familiar, a special dividend is a one-time dividend. This is good stuff for all investors, not just income-oriented investors, as it can really boost the price of the stock when it takes place. There were lot of special dividends paid in 2010, when it seemed that the favorable dividend tax rates would revert (they ended up being extended).

I remember running a screen that year to try to predict in advance who might make a special dividend payment. Here are a few attributes you should look for:

  • High Insider Ownership
  • Lots of Cash
  • A History of Special Dividends

These are fairly obvious. If the directors of a company own the stock, they are likely to want to take cash out of the company at a favorable tax-rate. If there is a lot of cash, this is easier, though some companies will certainly issue (more) debt too potentially. Finally, one would expect that if they did it in 2010 (like MASI), they will do it again.

I have already mentioned MASI, which fits all 3 of the criteria. DSW did too, while AEO and SCMR had no history but do have high insider ownership and lots of cash. Fellow Seeking Alpha contributor Stephen Rosenman made the case for Cal-Maine (NASDAQ:CALM), which I think is a good call (though I don't believe that they have declared one previously). I'll offer a few more that I think fit at least the first two criteria:

  • Shoe Carnival (NASDAQ:SCVL): No history, but they just started paying regular dividends and have a lot of cash and a lot of insider ownership
  • Franklin Resources (NYSE:BEN): All 3
  • NIC (NASDAQ:EGOV) - They pay specials each year, and I would think that they could go bigger than normal this year.
  • Raven Industries (NASDAQ:RAVN) - they paid specials previously and meet both criteria - this is a great time to buy this stock in any event - see my profile on the company from March

These five suggestions, including MASI, come from just my watchlist. I will certainly be on the lookout for more in the coming weeks. Analysts are already asking the questions, and, as we approach earnings season, we will likely hear a lot more talk (and declarations). One great way to keep up is to monitor Seeking Alpha's awesome library of transcripts and their search function. You can visit the Transcript page and search all transcripts for "special dividend". I'll make it easy - just click here. You can also set up a news alert with Google and be updated on the topic real-time.

Special dividends are potential alpha generators. If you believe in perfectly efficient markets, you likely would disagree with me, but, then again, you probably don't spend your time on Seeking Alpha! My observation is that the special dividend announcement leads to a spike. Of course, once the stock goes ex-dividend, the price declines, but, over time, it tends to work its way back up. Why? Because most investors don't properly value net cash in my opinion.

Investors who bet right in anticipating the declaration of a special dividend can bank the quick capital gain and sell before it goes ex-dividend, or they can take the dividend and wait for the stock to work its way back to the pre-dividend level. 2010 was big, but 2012 is likely going to be off-the-charts, as companies have more cash and the certainty of an adverse change in dividend taxation seems much higher. Spending time anticipating special dividends could, well, pay dividends - and produce capital gains!

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.

Additional disclosure: BEN and MASI are held in one or more model portfolios managed by the author at InvestByModel.com

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here