Does Dividend Stripping Work?

We think yes.

This view is based both on our own research and reputable external research.

A cornerstone study which forms the basis of our view was published by Dr. Elvis Jarnecic and Yubo Liu of the University of Sydney in June 2011.  You can download this study from the ASX website using this link.  The Ex-Dividend Performance of ASX200 Stocks Measured Against the 45-Day Holding Rule (January 2000 – March 2011).

Here is an excerpt from the study which frames the intention of the research:

This study examines the profitability of an ex-dividend based trading strategy across ASX200 stocks. This strategy requires that investors buy shares prior to the ex-dividend days and sell these shares 46 calendar days following the purchase of the shares. Investors receive capital gain, dividend payment and the values of franking credits as their return. This study aims to examine the performance of the ex-dividend trading strategy and investigate the factors that may impact on its profitability. The findings in this study should prove valuable for fund managers who trade around the ex-dividend days and provide them with insights that may enhance the performance of their strategies.

The study is a technical read; it is intended for an audience with a deep understanding of financial markets theory.  In this post, we will break the study down in simple terms and propose methods that can be used to exploit the ‘edge’ that is contemplated by the research.

What is Dividend Stripping?

Dividend stripping is an investment strategy whereby the investor buys shares leading into a dividend paying period and sells them shortly thereafter in an effort to produce returns in excess of normal market returns.

By doing so, an investor produces three component returns:

1. Capital gain / loss from owning the share.  That is the difference between the buy and sell price.  Clearly this return can be negative or positive.
2. Income return from the dividend
3. Franking credits (if any) that are attached to the dividend.

The sum of these three returns amounts to the total return of the investment.

Australia law requires that an investor must hold a share for 46 days to be entitled to the economic value of franking credits.  Most strategies therefore have a holding period of at least 46 days over the period that a company pays a dividend.  An investor could buy the day before the dividend and hold 46 days or buy 45 days prior and sell on the day dividend entitlement day; either way a constraint of dividend stripping is genrally a 46 day holding period.

The study considers three holding periods:

1. Buying 30 days prior to the Ex Date and holding 46 days.
2. Buying 6 days prior to the Ex Date and holding 46 days.
3. Buying 1 day prior to the Ex Date and holding 46 days.

Here is an extract from the study which visually depicts the holding periods considered.

Key Conclusions of the Study

A summary of the key findings which we find to be the most important in practice are:

• The ex-dividend trading strategy was profitable, as the weighted average abnormal returns are statistically positive. Period 1 (buying 30 days prior to Ex Day) was shown as the optimal entry point for this trading strategy suggesting investors should enter trading positions before the dividend announcement day. Positive abnormal returns were also found in Period 2 (6 days prior) and Period 3 (1 day prior).
• The level of franking credits had a positive impact on the profitability of the ex-dividend trading strategy. Ex-dividend events with high levels of franking credits delivered greater returns for investors.
• The profitability of the ex-dividend strategy varied across the 12 ASX200 GICS industry sectors. The strategy was not profitable in the Health Care sector, the A-REIT sector, the Telecommunication Services sector, and the Utilities sector. Significant positive abnormal returns were obtained in the remaining eight industry sectors. The best performances of the ex-dividend trading strategy were observed in the Information Technology sector, the Energy sector, and the Industrials sector.

In Practice

A flaw (cited by authors) of the best performing strategy (buying 30 days prior to ex and hold 46 days) is that a company generally announces a dividend often only five days prior to the qualifying date.  It is therefore often impossible to buy 30 days prior as the Ex Dividend date is not known at that time.

Fortunately most companies pay normal dividends twice a year, at around the same date, give or take a few days.  This allows investors to predict the dividend payment dates and buy 30 days ahead of the predicted date.

Our Dividend Stripping Strategy

Using a combination of this research report, other external research and our own we have defined a set of investment rules which aim to maximise the excess returns.

Qualifying Shares

• ASX500 index constituent, excluding the top 50 companies.
• 30 day average traded volume is $10 million per day.
• At least 2 year history of paying interim and final dividends.
• Not a participant of the Health Care, A-REIT, Telecommunication Services or Utilities sector.
• Prior equivalent dividend was 100% franked.
• Average yield of prior 2 equivalent dividends is > 2%.

Buy Timing

• Buy 30 Days prior to a predicted interim or final (not special) ex dividend date.  Prediction is made by adding 365 days to the prior equivalent dividend.

Sell Timing

• Sell on 50th day from purchase date.

Position Size and Portfolio Ranking

• Opportunities ranked by expected yield.  Higher yield is preferred.
• The top 5 scoring investments are held at any point in time.

Return Expectations

Based on research and experience we aim to produce 6% total average return on a given investment.  This is far from a certainty; past performance does not necessarily help predict future performance.  Things can change.

Dividends are concentrated in two periods twice annually.  This means that opportunities to invest tend to be in excess during ‘dividend season’ but scarce in between.  Using a capital allocation model of 1/5 capital per trade, an investor could expect an average of about 15 trades per annum, each with a holding period of 50 days.

Assumptions:

• Average of 6% total return per trade (capital return + dividend + franking credit).
• 1% costs (0.5% brokerage per trade).
• 15 transactions per year.
• Each position is 20% of allocated capital.

Using these assumptions we arrive at a return of 15% per annum.  Will it happen?  No.