Special Dividends May Not Be So Special

When  Microsoft (MSFT) announced its plan to pay a one-time "special" cash dividend of $3 per share, did you grab the phone and call your broker to put in a buy order? If so, you're not alone. The stock rose nearly 2% the day of the announcement on an astronomical volume of 200 million shares, compared with a 1.3% loss for the S&P 500 Index and a 2.2% loss for the Nasdaq.

This is not surprising. Typically, when a company announces a special dividend, its stock shoots up immediately as investors rush in to secure a quick payout. Those investors usually lose money, however.

That's because the giddiness created by a special dividend announcement causes a stock to shoot up immediately, even though theoretically the stock should be worth exactly the same whether it has plans to pay out a special dividend or not.

The only people who benefit from this jump in price are those who held the stock before the announcement was made. Those who buy after the announcement are paying for an event that creates no intrinsic value.

There's a logical reason why investing in companies that are set to pay a special dividend is a losing strategy. The present value of the future cash flows of the business is exactly the same whether a company pays out the cash to investors or not. There is no value created by a special dividend payout. Even so, the stock is bid up artificially by a subset of the investing public who craves quick, easy dividend payouts. This is a temporary inefficiency in the marketplace and will eventually correct itself. This correction usually occurs quickly.

Let's walk through a recent example of this scenario involving Value Line (VALU).

After the market closed April 23, Value Line announced it would pay a special dividend of $17.50 per share on May 19. Prior to the announcement, the stock had closed at $53.15. The next morning, the stock opened 34% higher, at $71.20. The opening price turned out to be the absolute highest price of the day--the stock closed that day at $64, a 20% gain for shareholders who had held the stock the day before, but a 10% ($7.20) loss for investors who bought right at the open.

Because no other event was announced in conjunction with the special dividend, and because the broad stock market declined about 0.5% that day, it seems clear that the only reason for the jump in Value Line's stock price was the announcement of the special dividend. Explain that, efficient market theorists.

Now, even though the investor who bought at the high price of $71.20 lost $7.20 by day's end, he still had the special dividend of $17.50 coming to him, right? And $17.50 minus $7.20 is a $10.30 profit, right?

Wrong.

Can you guess what happens at exactly the same time a special dividend is paid out? The stock should fall by the amount of the dividend--in this case, $17.50. In fact, Value Line's stock actually fell by $17.91. So, the person who paid $71.20 for the stock had a capital loss of $25.11 and only got a $17.50 dividend. That's a net loss on the whole shebang of $7.61, or 10.7%.

But the Value Line story doesn't end there. The stock continued its decline for a few more days. It went down another $2.96 the day after the special dividend was paid, and another $4.35 the next day. This is a typical scenario with regard to a special dividend. Dumb money rushes in to secure the dividend, is surprised to see the stock price fall by the amount of the dividend on payout day, gets confused and acts like a deer in the headlights, waits, loses more money in the next few days, and finally slinks away, tail between legs.

My advice: Avoid investing in companies that announce a special dividend until well after the dividend is actually paid out. Use the extra time to research the company further.