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Power of Dividends
If you have $10,000 cash to invest you have a wide variety of choices. Here we will consider two of those options, term deposits versus dividends.
First of all you could take the $10,000 down to your local Commonwealth Bank (CBA) branch and place it in a term deposit. Current deposit rates at the time this was written are 3.8% – 4.0% depending how long you are prepared to tie your money up for. So after 12 months you will receive interest of $400. Unfortunately it does not end there because the tax department treats this as income and taxes it at your personal rate. Assuming a 30% tax rate you will pay $120 and get to keep $280 from your investment.
Alternatively you could buy shares in CBA at the time of writing at $40. At this price CBA pays a dividend of 5.6%. At a lower price the yield is higher still. After 12 months you will receive a return of $560 in two payments during the year. But when it comes to tax time it gets even better. The income is taxable as before, but you get a credit for the tax the company has already paid. It will depend if your tax rate is higher than the company rate of 30% or lower as to the impact of tax on your total return. Assuming your tax rate is 30% then you get $560 after tax. If your tax rate is lower, as it is in self managed super funds, then your return could be even higher.
So investing for dividends from the share results in you receiving double the return after tax, $560 compared to $280 when you put your money in the bank. You are now exposed to movement in the share price, which could be good or bad, but remember your return on investment is determined when you buy the share by the dividend yield, so day to day fluctuations of the share price are not as important.
A profitable company has a choice as to what they do with the profit they make each year. The company can choice to reinvest the profit back into the business or they can choose to pay a portion of it to investors as a dividend. This dividend could be considered to be a reward to the investor for investing in the company in the first place. Typically you will find that smaller growing companies will reinvest most of the profit back into their business, while the more established companies will pay out more as a dividend.
If you imagine a company as a box of cash if they make profit the box of cash grows. If they choose to reinvest the funds then they can hopefully grow the box more the next year. If they pay a dividend out of profit the box will not grow as fast. In the perfect world the price of the share should relate directly to the amount of cash the company has in its box. The growth companies reward their shareholders in terms of share price appreciation, while the dividend paying companies provide a return along the way. In reality the share price can deviate wildly from the underlying value of the company.
Companies typically pay a dividend twice a year with the details of the dividend amount and timing contained in the annual and half yearly reports. If all is going well the company will over time increase the dividend that they pay.
Dates and Dividends
It can get very confusing when it comes to dividend time as there are a wide variety of different dates associated with the dividend payment. There is the cum dividend date, the ex dividend date, the record date and the payment date. All are relevant in their own right.
Cum Dividend – means the share is trading with the dividend attached and the buyers receive the benefit of the dividend.
Ex Dividend – if the share is purchased on the ex dividend date the buyer does not receive the dividend. The share must be purchased before the ex dividend date to gain access to the dividend.
Record Date – This is the day that the investors must be recorded as shareholders. Because the purchase of a share is not settled until T+3, 3 days after the share is traded the record date is 3 days after the ex dividend date.
Payment Date – This is the day the cheques are posted to the shareholders. This could be significantly later than the record date. It is not necessary to own the share on the payment date, but it is necessary to own it on the record date.
The most important date for most people is the ex dividend date as you must buy the share prior to this date to receive the dividend. On the ex dividend date the share drops in value, usually by the amount of the dividend.
Dividends can be quoted in cents per share or as a dividend yield. The yield is a measure of the return on investment that an investor will receive if you were to buy the share at the current price. It is calculated by dividing the total dividend in cents per share, by the price of the share. Dividend yields normally range from 0% up to 10%. In some cases the dividend yield can even push higher than this. The yield varies from day to day and for every investor and is determined by the price the investor pays for the share.
In Market Analyser you can find the dividend yield by going to the Security menu, and selecting Security Info. On the General tab enter a security’s code and click Request.
The “Yield “for Westpac bank is shown on the right hand side with details of when the dividend is to be paid shown on the Dividends tab.
Over time the dividend can change and the dividends usually rise as the company grows. This will ultimately alter the dividend yield. The price you pay for the share determines your dividend yield, the lower the price the higher the yield.
Before the company pays a dividend the company pays tax on the profit the company has made. The dividend is then passed on to the shareholder and the shareholder must declare this as income on the tax return. If this income was taxed in the normal way then the ATO would receive money twice on the same income, once from the company and again from the shareholder. While I am sure some people would expect this from the ATO it does not apply here due to franking credits. A shareholder can receive franking credits with the dividend. This allows them to claim a “credit” for tax that has already been paid by the company.
Dividends can be fully franked, partially franked or be not franked at all, dependent on how much tax the company has paid on the dividends. A company that has losses carried forward from previous years or a significant amount of overseas income is unlikely to pay a fully franked dividend.
When it comes to tax time you must declare the total dividend including the franking credits on your tax return as income. This is not the amount of the cheque that you received it is the amount of the cheque plus the franking credit amount which will be on your dividend statement. You can then claim a credit for tax that has already been paid.
Using Westpac as an example, the bank is currently paying a total dividend of $1.28 per share. If you owned 1000 shares of Westpac then you will receive a cash payment of $1,280 in dividends. The franking credits attached to this are $549 which means the total dividend received for tax purposes is $1,829.
So you tax return looks something like this.
Income from dividends $1829
*Tax Due on dividends @ 30% $549
Less Tax Paid (Franking Credits) $549
Tax to Pay $0
*Assuming a tax rate of 30%.
In your super fund the equation is similar but you benefit from the lower tax rate of 15%.
Income from dividends $1829
Tax Due on dividends @ 15% $274
Less Tax Paid (Franking Credits) $549
Tax Refund $275
45 Day Rule
Many people are under the impression that they must hold a share for 45 days to be eligible for the franking credit deduction. This tax ruling does exist, but only applies if the amount of franking credits you receive will be more than $5,000. This means you will have to be receiving dividends to the value of $16,667 or more. So for most investors this rule does not apply.
Dividend Reinvestment Plan (DRP)
Many companies offer the opportunity for shareholders to reinvest their dividends as shares rather than receive the dividend in cash. Some companies even offer a discount to the current price if you choose to reinvest your dividends. Discounts can be up to 7.5% of the price of the share which is a significant discount, though most DRP tend to be at smaller 2.5% discount or no discount at all. This allows an investor to not only benefit from the power of compounding in the price of the share it also allows an investor to benefit from compounding the number of shares as well.
Below are the share price and dividend amounts for Westpac Bank since 2004. Dividends are paid twice a year with the interim ex dividend date for Westpac in May and the final ex dividend date in November each year.
Up until the end of 2008 Westpac continued to raise its dividend payment each year, but as a result of the global financial crisis the dividend payment was reduced in 2009.
As an investor you have the choice to receive the dividends in cash or participate in the Dividend Reinvestment Plan. Westpac offers a 2.5% discount off the current share price if you choose to reinvest your dividends. In the table below we are assuming you purchased 1000 shares of Westpac in 2004 prior to the ex dividend date in May. These shares were then held right through until mid 2009.
If you receive all the dividends in cash the number of shares you own does not change, but as the dividend increases over time the amount of cash you receive also increases. Under the DRP Strategy the number of shares you have will increase each year and because you have more shares and the dividends are also increasing this growth compounds. By the end of the five years you own 1769 shares which is a 76% increase in the number of shares held.
The difference that the effect of the discount and compounding makes becomes significant over time. Starting out you are just $22 ahead with the DRP, but at the end of 5 years you are $2,206 ahead. At the peak in the share price in Nov 2007 you were ahead by almost $5,000. When you consider the total dividends received was $12,470 this is a significant margin.
Looking at your net position at the end of 5 years on 1000 shares you will receive $12,470 in dividends and a gain of just $1,540 in share value, thanks to the global financial crisis significantly reducing returns in the last year.
If you are receiving the dividends in cash your total return is $14,010 which is a return of 79.8%. This is a respectable result over 5 years and this would be even better if 2008 had not wiped out much of the growth in the share price. The dividend portion of the gain is a stunning 89% of the total return.
If you were to follow the DRP strategy you will receive no cash payments at all. You will own 1769 shares after 5 years adding 769 shares to your original 1000 shares. Your shares will be worth $33,766 a gain of $16,216 or 92.4%. In simple terms that is a return of almost 20% per annum in an environment where the share rose by less than 2% per annum.
Reinvesting your dividends is a powerful growth strategy and amplifies the performance of investing for dividends. You can get a discount on the share price when you reinvest your dividends and you pay no transaction costs as well. You then get to benefit from the growth in your original shares as well as growth in the shares you receive along the way. While keeping track of the positions can take a bit of work, because twice a year you buy a few more shares, it is well worth the effort.
Dividends for Investors
If you followed the information on Dividend Reinvestment Plans you can see the importance of the dividend to the total return that you receive when investing. In the case of Westpac up to 89% of the total return over the last 5 years can be attributed to dividends. The chart below shows the importance of dividends with the All Ordinaries Index showing the total change in price and the All Ordinaries Accumulation Index showing the results if dividends are all reinvested. There is a massive difference in the two results.
Investing for dividends has been shown to outperform the market over many years following a strategy known as the Dogs of Dow. On the first day of the year rank the top 30 companies in the Dow Jones Industrial Index by dividend yield. Buy an equal amount of each of the 10 companies that have the highest yield. Hold them for 12 months and then rebalance to the new dogs. This strategy has been shown to outperform the market for many years with a return of 17.7% per annum since 1973 compared to a market return of 11.9%.
The key here is to buy a share when the dividend yield is strong. By the very mechanics of the strategy the yield increases as the price goes down. So the cheaper you can buy the share the better the yield you will receive. The dividend yield also acts as a mechanism to avoid overpaying for a share. If the yield is low then avoid the share, until the dividend increases or the price drops to an acceptable level.
Remember from early on that strongly growing companies often pay a very small dividend as they continually reinvest the profit back into the company. The focus of this strategy is those companies that do pay a dividend. Growth investing requires a whole different set of rules.
One word of caution is to check out the ability of the company to continue paying a dividend. A rapidly falling share price can be a warning that the company is running into trouble and the dividend may be cut in the future. The stability of the dividend payment is important and reading the annual report will give you a good insight into the company’s likely future direction.
In summary dividends should be important to you as an investor and the overall returns you make. Opting for a strategy of reinvesting your dividends will allow you to grow your portfolio exponentially over time by taking advantage of the power of compounding.
Dividends for Traders
At one of the seminars I ran, one of the participants got really excited about the idea of trading for dividends. If a company is paying a dividend yield of 6 per cent they will usually make two payments of approximately 3 per cent per dividend. That is not a huge return on the face of it but what if you could employ leverage up to 20 times using Contracts for Difference (CFDs), the return now jumps to 60 per cent on the margin money used. That sounds much more attractive as a return. This theory has one major flaw: you will receive a 60 per cent return in cash on the day the dividend is paid but on average the share drops by the amount of the dividend on the ex-dividend date, losing 60 per cent of the margin requirement for a net return of 0 per cent.
But wait, all is not lost yet. There is an opportunity around dividend time, known as a dividend play. Take a look at the chart of National Australia Bank (NAB).
The dividend drop can be seen in the middle of the chart. The pattern around this dividend is typical of a share’s behaviour, climbing before the dividend, dropping the amount of the dividend on the ex-dividend day and then recovering after the dividend is paid.
By using a series of filters on the ASX market to select a list of large companies that are actively traded and pay a good dividend, I was able to create the chart of the behaviour around dividend time.
This chart shows a climb of close to 100 per cent of the dividend amount from 12 days before the ex-dividend date. The peak in the share price occurs two days before the ex-dividend date. On the day the ex-dividend date the shares drop by 80 per cent of the dividend amount at open, fall lower during the day to 140 per cent of the dividend amount and then recover to close down about 85 per cent of the dividend amount. Over the next five days, the share recovers another 40 per cent of the dividend amount.
The obvious strategy is to buy before the ex-dividend date and sell either the day before or on the date to take advantage of the run-up before the dividend payment. An alternative is to buy the share before the ex-dividend date and hold for the recovery after the ex-dividend date, selling five days later. Although this second strategy will provide stronger returns, holding the position through the ex-dividend date will dramatically increase the volatility in your portfolio. Not all shares recover immediately after the dividend drop, even though they do on average. Alternatively, you could buy on the ex-dividend date and sell a few days later to pick up the recovery after the drop.
Note these figures are averages and will not be seen in all cases. Stop losses are still an essential part of any strategy. The strategy works better in a bullish market environment than in a bearish one because the dividend effect is not strong enough to overcome rapidly falling share prices. There are definitely opportunities around dividend time for traders as well as investors.
Dividends offer a wide variety of opportunities to both investors and traders and can be used to enhance your returns. Dividends are fairly predictable as the timing and amount of the dividend is usually known before the ex dividend date comes around. MDS Financial will be posting up coming dividends on the blog at