How to play the fine art of ‘dividend stripping’

With reporting season finally out of the way, now's a good time to contemplate the opportunity for dividend stripping that comes around twice annually when companies reward shareholders with surplus cash during dividend season. While the art of dividend stripping – which involves buying a stock before it goes ex-dividend and selling it after – can be fiddly and potentially dangerous if you get it wrong, those who get it right can receive a nice little earner for their efforts. (Note: Article originally written 2017; recently updated where neccessary)

Contrary to popular opinion, there’s a lot more upside to dividend stripping than picking up the dividend and in most cases swapping it for the capital loss, which typically occurs due to shares falling ex-dividend by a corresponding amount. Everything being equal, well regarded blue-chip stocks paying regular (fully franked) dividends often receive sufficient support within rising markets to ensure the capital loss is actually smaller than the dividend gain – and this can be used to offset gains elsewhere.

However, be careful as some stocks can fall further than the dividend and then add insult to injury by underperforming ex-dividend, and this typically happens when stocks are paying big one-off dividends. In this case, ‘would-be’ dividend strippers can be left high and dry when there are too few natural buyers, and those who bought for the dividend end up being the same people who exit again.

The success of dividend stripping comes down to knowing when to both enter and exit, and historical dividend and share price data by Dividends.com.au shows that dividend stripping of the S&P200 index can provide a 6%-plus edge (over the S&P200 index) for a holding period of 46 days – assuming simple guidelines (see below the 45 day rule) are followed.

Bad strip – BHP’s journey

Here’s an example of how recent volatility around the BHP (ASX: BHP) price impacted the dividend stripping outcome.

The stock bounced from a (2015) high of $34.12 on 2 March, to $31.94 10 March only to fall another $1.58 a day later on the 11 March ex-date to $30.33 – which was greater than the 79¢ dividend and franking combined. Since then the share price has been bouncing lower.

BHP’s journey from around $40 early in 2014 to under $27 mid January 2015 shows how a good dividend outcome can be dependent on when you entered the stock.

Going for the trifecta

By timing dividend stripping to perfection, you stand to not only pick up the dividend, and the imputation credit, but also bag a capital gain too. This dividend stripping trifecta occurs when you buy shares several weeks before the ex-dividend date in the expectation that the (share) price will rally closer to this date as new investors (just like you) come on board – to capitalise on its dividend cash flow – only to sell after it goes ex-dividend.

It’s true, capital growth is more likely to be negative as a general rule due to the impact of the ex-dividend date entitlement. However, it’s not uncommon to see gains – especially within a bull market – when dividends are relatively small and the underlying company is a star growth stock, and digital advertising business REA Group (ASX: REA), Dominos Pizza Enterprises (ASX: DMP), and Carsales.Com Ltd (ASX: CAR) are classic examples.

Stellar performing growth stocks aside, quality companies with sound fundamentals and strong yields like, telcos, utilities, healthcare stocks and typically banks also have a tendency to rally a month ahead of their result; and assuming the result is good, they may continue doing so when the stock goes ex-dividend.

Good strips

Two real examples of really good dividend stripping outcomes include the following:

1. ANZ Bank’s (ASX: ANZ) entry price 46 days prior to ex-date (9 May 2013) of $28.55, and ex-dividend closing price of $30.59 – hence delivering a 10.8% dividend strip return (46 days) and a 5.9% edge over the S&P200 Accumulation Index.
2. Macquarie Group (ASX: MQG) which had an entry price 46 days prior to ex-date (13 May 2013) of $37.15, and ex-dividend closing price of $45.48, delivering a 26.4% dividend strip return (46 days), and a 5.4% edge over the S&P200 Accumulation Index.

Understand the 45-day rule

These outcomes are encouraging, but before embarking on executing the classic dividend strip, it’s important you get your head around what’s called the 45-day rule.

Imposed by the ATO, the 45-day rule is designed to stop savvy traders flagrantly dividend stripping by buying on the last cum-dividend date and selling on the first ex-dividend date to accumulate near risk-free franking credits.

However, you only need to satisfy the 45-day holding rule if you’re going to exceed $5000 in franking credits in the year. If so, the shares must be held for 45 days between the buy and sell dates, and the position must maintain a minimum 30% delta. In other words, you simply can’t hedge all of the stock specific risk away with options or other derivatives.

It would normally take a $150,000 share portfolio to put an investor within cooee of exceeding $5000 in franking credits annually. But if you’re within this danger territory, and couldn’t care less about franking credits and value income over capital gain, you’re at liberty to sell with your ears pinned back.

Don’t forget, if you’re a ‘smaller punter’, the 45-day rule won’t apply and the franking credit is effectively a 42% extra benefit that you can receive within a couple of days.

First principles

If you’re game to try your hand at dividend stripping, here are some first principle guidelines that you should remember.

1. 1. It typically works best when there are low interest rates, and rising markets provide good underlying support for quality stocks on the ASX200 paying fully franked dividends that you’re happy to hold.
   2. The opposite is also true in a rising interest rate environment although this doesn’t look like a short-term risk.
   3. The less reliable the stock is as a dividend payer, the less bankable a dividend strip strategy becomes.
   4. Buying early can reward you with the ‘perfect strip’, but it can easily turn into the classic nightmare when you buy ahead of the 45-day rule on the strength of a favourable consensus forecast, only to see the stock fall ahead of results.
   5. The 45-day rule only compounds the difficulty of successfully determining whether a share price will fall more or less than the dividend. However, you can minimise the potential for anguish by recognising whether, A) the company share price was already on a downward trajectory following any (earlier) profits warning before you bought in, B) the stock only had a strong yield due to a falling share price, and C) the pre-profit consensus dividend forecast was now out of date.
   6. Investors really need to receive the benefit of franking credits to make it work, and dividend stripping ideally complements those in pension phase who don’t pay tax.