Finding the Best Dividend Candidates

 | Nov 14, 2011 | 9:15 AM EST
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With a couple of large dividends coming due, it seemed like a good time to remind you about one of the nuances of dividend capture trading. The core challenge of dividend trading, of course, is to buy the stock, collect the dividend, then sell the stock at least at your purchase price. That way you break even on the stock and book the income. Selling at a loss that offsets your income would be pointless, naturally. Fortunately, for stocks in the right sectors or with certain characteristics, Mr. Market helps us out. It turns out that 60% to 70% of stocks bounce back to their pre-dividend price within a couple weeks, creating a tailwind that we exploit each quarter. So far, so good.

In order to find the best candidates, one of the characteristics for which we screen is dividend size. Dividends that are too small, say below 0.5% of the stock price, are fine but you just need to capture way too many of them to create meaningful return. In the other direction, very large dividends can be tempting, but can often indicate unforeseen risk. The grey area comes with "biggish" dividends. These are large enough that we know the stock will drop when it goes ex-, but not so large that we are taking on idiosyncratic risk. These dividends can be played safely, but with a qualification.

Two coming in this category are Wynn Resorts (WYNN), which will pay 4% on Nov. 21, and Prudential (PRU), which will pay 2.7% on Nov. 18. (As always, when I say "pay," I mean they go ex-dividend on that date.) Those dividends are quite large relative your run of the mill 0.5% to 1% we normally play. WYNN's is something of a special; they pay it now and then but not regularly. PRU's is the regular dividend, but it is an "accidental high yielder" because the stock is getting crushed along with the financials.

My game plan on playing both of these deviates from the usual in that I will not necessarily hold them until I get back to my purchase price. The name of the game in dividend capture is capital utilization, and you must carefully consider how long you hold a stock after it pays, since every day you hold it is a day you are not collecting income on a new trade. With these two, because the dividend is so large, I expect them to fall considerably after attaining ex-status, perhaps even as much as the dividend percentage. As I monitor them for a sell point, I will look at the total return on the trade. For instance, if WYNN falls 4%, then rallies over the following week or two so that it is down 2%, I will lock in the 2% loss on the stock. This, combined with my 4% dividend, is a 2% total return on the trade. This actually is double my usual target of around 1% return. The same with PRU: Watch the total return and feel free to sell at a loss that is less than the dividend, as this will produce a positive total return.

One other dividend note: the next couple weeks will be semi weeks. I initiated trades in Linear Technology (LLTC), Maxim Integrated Circuits (MXIM), and Microchip Technology (MCHP). I am a bit concerned about the semi group and tech in general, because the extreme shortage of hard drives caused by the Thai flooding is going to slow down the PC industry in a big way sometime this quarter and into the first quarter. (A great pair trade will be establishing long position names that make drives and shorting any names that make other components.) Having said that, the analog names are some of the most stable of the group, because they sell into numerous industrial applications, and their margins are gargantuan. These are not long-term holdings, but we can capture solid dividends and get out on any small group rally between now and year-end. LLTC pays 0.74% on Nov. 16, MXIM pays 0.82% on Nov. 21, and MCHP pays 0.95% on Nov. 17.

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