big payouts

A significant number of publicly traded companies in the US are declaring large special (i.e., one-time) dividends to be paid before yearend.  In every instance I’ve seen–the latest being LVS and COST–the stock has gone up significantly on the announcement the company is taking this action.

two tax reasons

There are two reasons for this, the first of which relates to the current income tax preference for dividend income (a maximum 15% federal tax rate) versus “ordinary” or “earned” income (a maximum of around 40%).  They are:

1.  The reasonable supposition that the income tax on dividends will go up in January, either as part of a political deal to avoid the “fiscal cliff” or in a subsequent, more general reform of the tax code whose provisions are made retroactive to January 1st.

A dollar in dividend income today nets the taxable recipient $.85.  In January, it may only have an after-tax value of $.40.

Let’s say, to make the numbers easy, a stock is trading at $100 a share.  It has $8 a share in excess cash.  It has no sure-fire investment projects that have the potential to make large future gains, so that $8 will remain $8 in present-value terms.  For a taxable investor, that $8 a share inside the company is worth $4.80 if it will be paid out after December 31st.

If, however, the entire $8 is paid out in 2012, it is worth $6.80 after-tax–a $2 difference.  So the taxable investor is $2 better off because of the dividend payment.

That’s not the whole story, either.

2.  When this stock goes ex-dividend, its price will presumably drop by about $8, simply because the ex-dividend buyer isn’t entitled to the $8 dividend.   In a very simple world, the $100 price falls to $92.

For the taxable investor who buys the stock for $100 right after the dividend announcement, the fact of going ex-dividend “manufactures” a short-term tax loss of $8.  This loss can be used to shield  otherwise taxable income at the holder’s highest marginal tax bracket.

If that rate is 40%, then the tax loss is worth $3.20.  (For what it’s worth, the part of T. Boone Pickens’ reputation that doesn’t come from relentless self-promotion is based on creating dividend situations like this on a massive scale.  There was also a one time a type of investment vehicle, called a dividend capture fund, whose main purpose was to capture the tax benefits of dividend-paying stocks going ex. )

#1 and #2 together make $5.20.  So the declaration of the $8 dividend has made the stock 5%+ more valuable to taxable investors than before.  In theory, the stock should rise on the dividend announcement until that “extra” value disappears.  That’s also what’s actually happening.

Of course, to use the short-term loss the holder has to sell the stock, creating downward pressure on the price once it goes ex-dividend. But at the same time, non-taxable investors, for whom there are no tax benefits, may be attracted to the issue and lend support because of the substantially lower price.

worth looking for?

For highly specialized professionals, yes.  For the rest of us, no.  One of the first lessons I learned as a portfolio manager is that you should focus all your time trying to find the 30% gains, and the 50%s and the 100%s.  If you see a 5% on the ground in front of you, pick it up.  Otherwise, the gain is too small to spend time on.

So, while it’s nice to understand why a stock is going up, these aren’t worth chasing.  Nor, in my view, is searching for stocks where a large potential special dividend payment is the major attraction worth the time and effort.