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Letter # 36

The latest news to keep you informed

to you all!

Judging by the response I have been getting to my last two letters, there must be a lot of people out there who own shares and who want to learn more, so here it goes:

'But it pays a good dividend' is a justification used by many traders for hanging on to a losing share. This is the equivalent to saying that you are a compulsive gambler because they provide free coffee at the casino. One of the golden rules is that you don't buy a rubbish stock for a big dividend. Investors are always looking at the dividend list and wondering whether they should buy XYZ because it has a 10 per cent yield. You never buy a rubbish stock! It yields 10 per cent for a reason - usually because the share price has fallen so far the yield has gone up.

I do like the dividends I receive; indeed, I partly depend on them for my living but there may be bigger rewards with companies that pay little or no dividends at all. You see, contrary to popular opinion, companies that pay dividends may not have their shareholders' interests at heart. Companies that retain their dividends, and invest in developing their business, automatically increase their earnings per share. Investing in a share buyback scheme, rather than paying a dividend, would naturally drive the share price upwards.

However, regardless of your views regarding dividends, you should know how to treat them and trade with them if you are planning to use them as a part of your strategy. When the market prepares for a dividend payment, the share price will often increase as demand increases due to the promise of a dividend payment. Once the stock goes 'ex-dividend', the price of the share will often fall significantly.

How much is the share price likely to drop when it goes ex-dividend? This depends on whether the dividend is fully franked, partially frankly, or unfranked. A fully franked or partically franked dividend means that the company has paid tax on the dividend before you receive it. This makes it possible for you to pay less tax on income from shares due to 'dividend imputation' tax credits. (And franking credits are now real cash. It used to be that you could only offset them against tax payable, but if you can't offset against tax, you can now claim them back as cash.) Unfranked dividends are considered to be of less value to shareholders as they must shoulder the full tax burden.

As a rough guide, for unfranked dividends, the share will fall by approximately the price of the declared dividend. Fully franked dividends will mostly show a share price decrease of more than the declared dividend. Although other market conditions also come into play, the drop in share price for a fully franked dividend will usually be between 20 per cent and 60 per cent in excess oof the declared dividend price. To make calculations simple, I use 50 per cent in excess of the declared dividend as a guide. For example, a fully franked dividend of 50¢ per share may result in a share price drop of 75¢.

For partially franked dividends, the share price drop is affected by the percentage of franking. For example, a 75 per cent franking on a 50¢ dividend may result in a share price drop of approximately 69¢ which I calculate as follows:

50¢ x 50 per cent = 25¢
75 per cent franking of 25¢ = 18.75¢
50¢ + 18.75¢ = 68.75¢ = 69¢ (rounded)

Therefore, the approximate drop in share price will be 69¢.

Uptrending shares will often recover the ex-dividen gap within five to seven trading days. This gives brokers the opportunity to sell you that oh-so-easy line about dividend stripping - but watch out, dividend stripping is not that simple and there are costs involved.

Dividend stripping means to buy the stock before the ex-dividend date, hold it for at least 45 days to qualify for the franking credits, then sell it and move on to the next stock. In the process, the investor collects the dividend, the imputation credit and hopefully a capital gain. Brokers say the strategy works best in a rising market, as the likelihood is reduced of the share price falling more than the dividend payment once the stock goes ex-dividend. For example, a $20 stock is paying a $1 dividend. In theory, the day it goes ex-dividend - that is, when the shareholder register is closed - the stock should fall by the dividend amount. In a rising market, it may fall only 80 and recover completely before the 45-day sell date.

Why hold the share for at least 45 days? Because the Tax Commissioner introduced a regulation known as the '45-day rule' under which franking credits received from shares held for less than 45 clear days cannot be used to reduce an income tax liability. It doesn't matter whether the shares were held 45 days before or after the ex-dividend date, as long as the ex-dividend date is somewhere inside the 45-day holding period. This rule only applies to taxpayers who claim more than $5,000 in franking credits. (To the extent that a taxpayer is denied a franking credit, there is no requirement to 'gross up' the dividend to include an imputation credit in the assessable income.)

Tax considerations should never influence your trading decisions, however, you should keep the capital gains tax rules in mind. Capital gains are taxed at only half the rate if the underlying investments have been held for at least twelve months.

Best wishes and from us all!
Peter & Padma & Malty& Rover
riverbend@batemansbay.com
12 May 2006

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