The Growing Power of Dividends
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Topic: Dividend Stocks
August 9, 2024|by Scott Clayton
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How does the dividend capture strategy work in Canada?
“Dividend capture strategy” returns are the trading technique of buying a stock just before the dividend is paid, holding it just long enough to collect the dividend, then selling it. If you can sell it for as much as you paid, you have “captured” the dividend at no cost, other than the transaction costs. A dividend chaser employs this strategy to try to profit from dividends.
This strategy is executed by buying a stock just before the ex-dividend date, so that you will be a shareholder of record on the record date, and will receive the dividend. Because the stock falls by the amount of the dividend on the ex-dividend date, the strategy then calls for you to wait for the stock to move back to the price where you bought it before the ex-dividend date. At this point, in order to benefit from the dividend capture strategy returns, you sell the stock for a break-even trade. This is the aim of the dividend chaser.
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How can you use a dividend capture strategy calendar and dates?
A dividend capture strategy calendar can be used to track ex-dividend dates, helping investors time their purchases and sales of stocks to maximize dividend income while minimizing holding periods.
The declaration date is the date on which a company’s board of directors actually sets the amount of the next dividend. Typically it is a number of weeks in advance of the actual payout date.
The record date is the date on which a person has to actually own shares in the company in order to receive the declared dividend.
The ex-dividend date is typically the last business day before the record date. The ex-dividend date is in place to allow pending stock trades to settle. In short, the security trades without its dividend any day after the ex-dividend date. If you buy a dividend-paying stock one day before the ex-dividend you will still get the dividend; if you buy on the ex-dividend date or after, you won’t get the dividend. The reverse is true if you want to sell a stock and still receive a dividend that has been declared: you will need to sell on the ex-dividend day or after. A dividend chaser must carefully time their trades around these dates.
The payable date is the date on which the dividend is actually paid out to the shareholders of record.
Can you realistically profit from dividend capture in Canada?
Profiting realistically from dividend capture in Canada is challenging due to market efficiency and transaction costs.
A dividend capture strategy can pay off when stock markets are rising. Of course, any strategy that leads you to buy can pay off when stock markets are rising. However, you have to pay a brokerage commission to buy the shares and a commission to sell. The commissions can eat up much of the dividend income. They may exceed the dividend income. This makes it difficult for the average dividend chaser to profit.
In addition, the mechanical aspects of the strategy may lead you to disregard the three key parts of our Successful Investor approach: investing mainly in profitable, well-established companies; spreading your investments out across most if not all of the five main economic sectors; and downplaying or avoiding stocks in the broker-media limelight.
Dividend capture strategies may have appeal for securities dealers or brokers executing huge trades with very low transaction costs. But for the average investor, there’s little chance of making a significant profit.
Should I be buying and holding top dividend-paying stocks?
You will profit more from focusing on buying and holding companies that have maintained or raised their dividends during both economic and stock market downturns.
These companies have proven themselves able to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth. This is a better approach than being a short-term dividend chaser.
Dividends from these companies will be an important contributor to your long-term gains, and dividend-paying stocks tend to expose you to less risk than non-dividend-payers. That’s why the majority of your stocks should be dividend-payers. As you get older and closer to retirement, you should consider raising the proportion of dividend-paying stocks in your portfolio, to cut risk and improve the stability of your investment results.
What are reasonable dividend capture strategy returns?
A reasonable dividend payout ratio typically falls between 30% to 50% of a company’s earnings, balancing shareholder returns with the company’s need for reinvestment and financial flexibility.
One of the best ways to judge whether a company will keep paying its dividend, or even increase it, is the dividend payout ratio. This simply measures what portion of a company’s earnings or cash flow are allotted to paying dividends.
If a company keeps its payout ratio fairly steady, and its earnings grow, the amount you receive in dividends should also grow. However, if a company must keep paying out a larger and larger percentage of its earnings just to maintain the dividend, it is reasonable to wonder whether the company is in decline and the dividend is in danger of being cut.
You need to look at other factors as well, of course. The company may be going through a low cycle in its industry, or have a temporary problem it has a good chance of solving.
In summary, the dividend capture strategy involves buying a stock just before the ex-dividend date to receive the dividend, then selling it after the price recovers to break even. While potentially profitable, this strategy has several risks for small investors. Transaction costs can eat into or exceed the dividend income. The strategy may also lead investors to ignore key principles like investing in profitable companies, diversifying across sectors, and avoiding hyped stocks. Instead of being a dividend chaser and going after short-term dividend capture returns, investors are better off buying and holding established dividend-paying stocks for the long term. Focusing on companies with reasonable and stable dividend payout ratios is a more secure way to benefit from dividend income and achieve an attractive balance of safety, income, and growth in a portfolio.
What are the risks of using the dividend capture strategy in Canada?
Risks of the dividend capture strategy in Canada include stock price drops after the ex-dividend date, transaction costs eroding profits, and potential tax complications.
What are the tax implications of dividend capture in Canada?
In Canada, dividends are taxed at a lower rate than regular income, but frequent trading may lead to higher capital gains taxes.
Using a dividend capture strategy involves frequent trading, which can lead to several tax considerations:
- Capital gains/losses: Each time you sell a stock, you may realize a capital gain or loss, which is taxable.
- Superficial loss rule: If you sell a stock at a loss and repurchase it within 30 days, the loss may be denied for tax purposes.
- Income vs. capital: If your trading is frequent enough, the Canada Revenue Agency (CRA) might view your activities as a business, taxing your profits as income rather than capital gains.
- Foreign dividend withholding: For US or other foreign stocks, there may be withholding taxes on dividends.
- TFSA/RRSP considerations: Using these accounts can shelter dividends and capital gains from tax, but there are contribution limits and potential penalties for frequent trading.
- ACB tracking: You’ll need to carefully track your adjusted cost base for each security to accurately report capital gains/losses.
While the dividend capture strategy may seem appealing, it comes with significant challenges and risks, particularly for individual investors in Canada. The strategy’s success is hindered by market efficiency, transaction costs, and potential tax complications. Instead of pursuing this short-term approach, investors are generally better served by focusing on long-term investments in established, dividend-paying companies with stable payout ratios. This more conservative strategy aligns with the principles of investing in profitable companies, diversifying across sectors, and avoiding stocks in the limelight. Ultimately, a buy-and-hold approach to quality dividend stocks offers a more reliable path to balancing income, growth, and safety in an investment portfolio, especially as investors approach retirement age.
What have your experiences been with the controversial dividend capture strategy?
Aside from the dividend capture strategy, what controversial investing strategies have you used, and what were the results?
This post was originally published in November 2016 and is regularly updated.
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