Diary of a Dividend Diva: 2 + 2 = 8

 | Sep 07, 2013 | 8:00 PM EDT
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A warm welcome to all the visitors to our Real Money Open House!

Although I write about many subjects, my specialization here involves strategies for generating dividend income. I post a regular column, "Diary of a Dividend Diva," that offers insight into an income-generation strategy I call "dividend rotation." The strategy is also known by similar names, such as "dividend capture," but the gist is the same: trading into and out of stocks around the ex-dividend date in order to raise your income generation without increasing your risk.

Investors face a fundamental challenge at the moment. With interest rates pathetically low on U.S. Treasuries -- even after the upward drift this summer -- bonds cannot provide a living-wage income stream. Safe equities offer a somewhat better yield, but even a 2%-to-4% yield is not going to put a roof over your head. Receiving 8%-to-10% in dividend income requires moving out the risk spectrum, since a yield that high often reflects significant company-specific risk that could result in a dividend cut or a significant decline in the stock price.

My dividend-rotation strategy, which entails buying and selling a stock around its ex-dividend date, generates 8% to 10% a year in dividend income. The strategy exploits an anomaly in how dividends are paid: They are not prorated for your holding period.

In fact, in order for you to be entitled to the dividend, you need only own the stock overnight. If you own it the day before it goes ex-dividend, the next morning you are entitled to the full payout for that quarter! You are free to sell the stock the next day, the day after, or whenever, and you get that full dividend. Contrast this with bonds: When you trade a bond between interest payments, you either pay or receive a prorated payment for the days you are entitled to income.  

Consider how you might allocate a block of capital. In other words, for a $100,000 portfolio, what sort of income could a $10,000 block generate for you?

For one example, let's look at Reynolds American (RAI), a classic yield stock with a 5.3% dividend that's owned by many income investors. If you buy and hold $10,000 worth of the stock, you receive $133 each quarter, or $530 a year. However, your $10,000 only earns that $133 on Sept. 6, the next ex-dividend date. The rest of the time between ex- dates, your capital is not working for you, as far as income generation is concerned. Why not sell Reynolds American after the ex- date, and buy some Altria (MO) with that capital instead? Altria yields 5.7% and will pay you $142 if you own it on its ex- date of Sept. 16.

If you do this "rotation" through two dividend paying stocks, in this example in the tobacco group, your $10,000 has now generated $275 of income in the quarter. That annualizes to an 11% yield! Through some smart trading, your capital is now generating an 11% yield, and at the same time you're avoiding a single stock yielding at 11% that would represent significant risk.

As an astute potential subscriber to Real Money -- and all our subscribers are very astute -- your natural question is: What is the catch? Indeed, there is always a catch, isn't there?

The catch here is that dividend-paying stocks are supposed to decline by their respective dividend amounts on the day they go ex. This is supposed to reflect the loss of the right to the dividend. So if you own Reynolds American at $47.89 on Sept. 5, on Sept. 6 it should trade $1.33 lower to $46.56.

In fact, the stock did drop that morning. Then it bounced and closed the day at $47.40. If you had sold at the close (though it was even higher intraday), your investment of $47.89 would have generated $48.73 for you -- the sale proceeds of $47.40 and the $1.33 dividend. That is a 1.75% return for a one-day holding period. Keep in mind that you do not want or need to mechanically sell on the ex-date. You want to wait until the stock gets back to at least your purchase price. Then you collect the dividend with no capital loss, and you can move onto the next dividend.

Source: Yahoo! Finance

Many skeptics argue that the stock will not return to your purchase price and that, therefore, you will always lose in capital what you've made in income. But if that were consistently the case, dividend-paying stocks would always go down until they were at zero! Obviously they rebound. What you want, as a dividend-rotation investor, is to avoid stocks that return to the purchase price slowly -- those that you might have to hold for three months in order to make back your money. If a stock trades in that sawtooth pattern, why bother trading it?

When I first entered dividend-rotation trading over a decade ago, I studied how stocks behaved ex-dividend, parsing out which groups were good to trade and which were not. It turns out that most stocks are very friendly to dividend-rotation trading. I looked at the price action on all dividend-paying stocks going back a decade. Through bull market and bear market, 60% to 70% of stocks have consistently traded back to their pre-dividend price within two weeks.

In other words, without even doing any research or using any judgment or insight, you have a 70% chance of correctly trading a stock around the dividend. Of course, if you extended the study period out beyond two weeks, the percentage of stocks returning to cost would be even higher.

The table below shows a real-life example of how I rotated through a series of dividend-paying stocks in the same industry. By using the same industry and reasonably similar yield, I held my stock-specific risk constant while generating a superior yield.

If you are still skeptical, I would offer one final point: I have been running the strategy for several years with very impressive returns. The strategy is definitely not mechanical -- one needs to exercise judgment and accumulate experience in order to execute dividend rotation well. But if you put in the time and effort, you can be rewarded with an attractive income stream without taking excessive risk.

A final thought: All of us here at Real Money invite you to subscribe. The level of discourse and insight are impressive, and I am amazed at the breadth and expertise of the contributors to the site. I also invite you to follow my postings as the Dividend Diva. My goal is to guide you to progressively better levels of income generation. Such results really are within your reach.

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