Gary Dvorchak

Stock quotes in this article:

txn

stx

A warm welcome to all the visitors to our Real Money Open House! This weekend you will have the opportunity to sample many investment strategies, from deep value to earnings momentum to technical analysis. We think you will be impressed by both the breadth and depth of knowledge of our contributors. I never cease to be!

My particular specialty is a strategy I call dividend rotation, but is also known more generally as dividend capture. I write about it periodically under the column name Diary of a Dividend Diva. (In case you are wondering, by the way, the diva moniker is simply a rhyming mechanism.)

The goal of the dividend-rotation strategy is to generate a higher level of dividend-based income than you can do by simply buying and holding high yield stocks. Investors have faced a fundamental challenge since the Federal Reserve implemented its zero-interest-rate policy. With rates pathetically low on U.S. Treasuries — even after the upward drift in 2013 — bonds cannot provide a living-wage income stream. Safe equities offer a somewhat better yield, but even a 2%-to-4% yield is barely satisfactory.

Meanwhile, if you buy and hold in order to generate 8% or more in dividend income, you’ve moved out the risk spectrum. After all, a yield that high often reflects significant company-specific risk that could result in a payout cut or a significant decline in the stock price.

My dividend-rotation strategy is straightforward: Trade into and out of stocks around the ex-dividend date in order to raise your income generation without increasing your risk. By doing this, you can generate 8% to 10% a year in dividend income using stocks that yield 2% to 4% — lower-risk stocks within the universe of dividend payers.

The strategy works because it exploits an anomaly in how dividends are paid: They are not prorated for your holding period. In fact, in order for you to be entitled to the dividend, you need only own the stock overnight. If you own it the day before it goes ex-dividend, the next morning you are entitled to the full payout for that quarter. You are free to sell the stock the next day, the day after or whenever, and you get that full dividend. Contrast this with bonds: When you trade a bond between interest payments, you either pay or receive a prorated payment for the days you are entitled to income.

Consider how you might allocate a block of capital. In other words, for a $1 million portfolio, what sort of income could a $100,000 block generate for you? (This is an arbitrary number to simplify the math. I would not recommend putting 10% into any position, be it a dividend capture or just an investment.)

For one example, let’s look at Texas Instruments (TXN ), a blue-chip technology stock with a respectable but unexciting 3.2% yield. The Texan is owned mostly by growth investors, rather than income investors, and that is key to making this strategy work (more on that later). If you buy and hold $100,000 worth of the stock, you receive $799 each quarter, or $3,196 a year. But your $100,000 only earns that $799 on July 29 — the ex-dividend date in this example.

The rest of the time between ex- dates, your capital is not generating any income for you. So why not sell Texas Instruments after the ex- date, and buy some Seagate Technology (STX ) with that capital instead? Seagate yields at 2.9% and will pay you $920 if you own it on its ex- date of Aug. 5. If you do this rotation through one dividend-paying stock during each month of the quarter — using technology group for this example — your $100,000 has now generated $2,698 of income. That annualizes to a yield of 10.8%. Through some smart trading, your capital is now generating an 11% yield, and at the same time you’re avoiding a single stock yielding at 11%, which would saddle you with significant risk.

As an astute potential subscriber to Real Money — and all our subscribers are very astute — your natural question is: What is the catch? Indeed, there is always a catch, isn’t there?

The catch here is that dividend-paying stocks are supposed to decline by their respective dividend amounts on the day they go ex-. This is supposed to reflect the loss of the right to the dividend. So if you own Texas Instruments at $39.11 on July 26 (the Friday close of trading), on Monday, July 29, it should trade $0.28 lower to $38.83.

In fact, the stock did drop that morning to $38.59, but then it rallied back above the July 26 price two days later. Keep in mind that you do not want or need to mechanically sell on the ex- date. You want to wait until the stock gets back to at least your purchase price. Then you collect the dividend with no capital loss, and you can move on to the next dividend. Obviously there are no guarantees as to how any given stock will trade, and a two-day holding period is the exception, not the norm. But you would be surprised at how often dividend stocks quickly bounce after going ex-div.

Texas Instruments (TXN) — Daily

Source: Yahoo! Finance

Despite these examples, many skeptics argue that stocks will not return to your purchase price and that, therefore, you will always lose in capital what you’ve made in income. But if that were consistently the case, dividend-paying stocks would always go down until they were at zero. Obviously they rebound. What you want, as a dividend-rotation investor, is to avoid stocks that return to the purchase price slowly — those that you might have to hold for three months in order to make back your money. If a stock trades in that saw-tooth pattern, why bother trading it?

When I first entered dividend-rotation trading over a decade ago, I studied how stocks behaved ex-dividend, parsing out which groups were good to trade and which were not. It turns out that most stocks are very friendly to dividend-rotation trading. In one study I did, I looked at the price action on all dividend-paying stocks going back a decade. Through bull market and bear market, 60% to 70% of stocks have consistently traded back to their pre-dividend price within two weeks.

In other words, without even doing any research or using any judgment or insight, you have a 70% chance of correctly trading a stock around the dividend. Of course, if you were to extend the study period out beyond two weeks, the percentage of stocks returning to cost would be even higher.

The ultimate proof of the effectiveness of a strategy is in the results, and I have been running this strategy for several years with very impressive returns. The strategy is definitely not mechanical — one needs to exercise judgment and accumulate experience in order to execute dividend rotation well. But if you put in the time and effort, you can be rewarded with an attractive income stream without taking on excessive risk. The chart below shows the performance of my dividend-rotation partnership since inception in 2009. Keep in mind that I have been involved in the strategy since 2004 via various vehicles, including other limited partnerships, and even through a closed-end fund that my former firm publicly debuted in 2007.

A final thought: All of us here a Real Money invite you to subscribe. The level of discourse and insight are impressive, and I am continually amazed at the breadth and expertise of the contributors to the site. I also invite you to follow my postings as the Dividend Diva. My goal is to guide you to progressively better levels of income generation. Such results really are within your reach.

At the time of publication, Dvorchak had no positions in the stocks mentioned.