Special Dividends: Not So Special After All

Note: This article is an excerpt from a Nov. 30 message to Morningstar DividendInvestor subscribers from DividendInvestor editor Josh Peters. Click here to learn more about DividendInvestor.

It's been nine days since my last update--I couldn't resist taking Black Friday off, even if doorbusting wasn't remotely part of my agenda--and so it is that we find ourselves nine days closer to the fiscal cliff. If you read the news and can't find any substantive progress between the negotiating parties in Washington, well, I can't find any either, so I hope you won't mind if I skip ahead to the latest cliff-related phenomenon on Wall Street: special dividends.

I'm not much of a fan of special dividends, and I never have been. In fact, I'd like to dispense with the word "special" right off the bat, because these payments should not be (as Merriam-Webster puts it) "held in particular esteem." I'd rather call them "irregular" dividends, which is a fairer reflection of their limited value to income-seeking investors.

On one level, any dividend is better than no dividend at all, at least as long as the dividend doesn't court financial distress for the company paying it. However, that doesn't mean that all dividends are equally useful. Regular dividends--the kind we seek, which are paid at predictable intervals and per-share rates--are valuable for investors in large part because they create a stream of income. When a regular dividend is also meaningful (yields of 3% and above), reliable and growing, that's something I consider genuinely special. And when that dividend is paid out of a financially healthy and competitively advantaged business, and the stock is available at a reasonable valuation, the stock might well be worth adding to long-term income portfolios.

Irregular dividends, by definition, do not create an ongoing stream of income. These one-off payments may unlock value to which shareholders were previously denied access, but just as easily, they can also highlight problematic capital-allocation policies for businesses paying them.

 Costco's (COST) recently announced irregular dividend of $7.00 a share is as good an example as any. It's a great company, but it certainly doesn't qualify as a great dividend payer. I'll grant that this one-off distribution is better than nothing, not least because the company's returns on equity have arguably suffered somewhat from too little debt (Costco is borrowing the money it needs to make this payout). Interest rates are so low that Costco's future earnings are unlikely to be hurt much by the added financing costs, and there's certainly nothing wrong with the timing, given the potential for tax rates to rise sharply next year. But Costco didn't change its regular dividend rate of $1.10 a share annually, which represents a payout ratio of less than 25% and provides shareholders with a yield only slightly above 1%.

Reflecting the possible benefits of a bit more debt, it makes sense that Costco's share price got a bump from the announcement. However, I think the size of the stock's gain on Wednesday, Nov. 28 ($6.07 a share, or 6.3%) actually reflects poorly on Costco. If investors would prize this windfall so highly, doesn't that suggest that Costco should have been paying bigger regular dividends all along?

Or has the market simply overreacted to what is actually a phantom opportunity?

* Before an irregular dividend is announced, an investor (or, more likely, a trader) could conceivably anticipate it in advance and then benefit from a post-declaration bounce in the stock price. In practice, though, this is no easy task. It takes more than simply identifying those firms with large and unnecessary cash reserves, or even the presence of concentrated inside owners who would have the most to gain (a common theme with many of the irregular dividends announced to date). In the end, an irregular dividend is an act (however benign or benevolent) of corporate caprice. Even with all the necessary preconditions, the issue still hinges on management's choice to do so--and if a stock's price has already been marked up in anticipation of an irregular payout, failing to get one could lead to a capital loss. Speculators seeking irregular dividends can use screening tools to help narrow the range of candidates, but in the end they might as well flip a coin--and long-term investors usually serve themselves best by staying out of the coin-flipping business.

* After an irregular dividend is announced, the math becomes much simpler--and even less appealing. Just as with any regular dividend, the stock price will automatically adjust lower by the exact amount of the dividend at the market open on the ex-dividend date, leaving no net gain. Let's say a hypothetical company with a $20 stock price declares an irregular dividend of $2 a share. A hypothetical investor then buys 100 shares for $2,000. All else being equal, he'll have $1,800 worth of stock after the ex-dividend date plus a $200 dividend check on its way, which creates a net profit of zero. Any other gain or loss will represent nothing more than the ordinary (hit-or-miss) dynamics of a short-term trade. Yet the final math can actually be a bit worse than that: In addition to the cost of commissions and bid-ask spreads, that dividend represents taxable income even though the stock price has dropped. If our investor holds on to the stock in the all-else-equal scenario, our investor ends up with $1,800 of stock, a $200 dividend and a $30 tax bill. (The capital loss associated with the ex-dividend price adjustment can only be claimed if and when the stock is sold.)

This explains why I haven't spent any time sniffing around for irregular-dividend candidates: I simply don't think there's any meaningful profit to be made on a consistent basis. I'm watching the phenomenon with a certain bit of amusement, seeing companies that (for the most part) are failing to provide their shareholders with worthwhile regular dividends suddenly become fervent-but-temporary converts to the cause of income. But it's hard for me to gin up any more enthusiasm than that for something which is inherently a short-term game.

I'm also not the least bit surprised that none of our 36 portfolio holdings--despite their obvious devotion to paying dividends--have declared any irregular dividends this year. In fact, in the nearly eight-year history of DividendInvestor's model portfolios, only three of the more than 900 individual dividend payments we've collected have included irregular amounts. (Of these, two came from longtime Harvest holding  AmeriGas Partners  . Since they were related to asset sales that could trigger additional taxable income for limited partners, the extra distributions had a clear and prudent purpose.)

A critical part of our investment process is finding companies that already pay regular dividends at a level that reflects their capacity to pay. I look for a healthy, sustainable balance between generous yields, internal reinvestment opportunities, and margins of safety to protect dividends during downturns. A company sitting on a giant pile of idle cash while paying a piddling regular dividend ( Apple (AAPL) comes quickly to mind) is sending none-too-subtle signals about its priorities. Either it doesn't have sufficient confidence in its long-term future to embark on a more substantial course of regular dividends, it doesn't want to repatriate cash from overseas and pay additional U.S. corporate income taxes (a key problem for Apple and certain other large multinationals), or it just doesn't care to reward shareholders with meaningful regular dividends.

Of course, I don't think we've seen the last of the irregular-dividend phenomenon yet. It has a few more weeks to play out, but since the process of declaring and distributing a dividend usually takes at least a week or two, the anticipation game will probably be over before Christmas. Long-term investors in companies that haven't been paying acceptable regular dividends might end up slightly better off than before, and a few short-term traders could wind up with bigger tax bills, but the burst of activity seems unlikely to leave a lasting mark on the market except for this: These irregular dividends are yet another reminder of just how stingy most American corporations when it comes to paying regular dividends.

In a related but different phenomenon, a few companies--including  Wal-Mart Stores (WMT) and Leggett & Platt (LEG)--have accelerated the payment of regular dividends that were scheduled for early 2013 in order to lock in this year's tax rates for shareholders. While there's no short-term trading or long-term investment opportunity here, I find this tactic praiseworthy. By itself, a small change in timing doesn't reflect poorly on the capital allocation practices of the payers, and it may well save shareholders from an avoidable increase in taxes (including, especially in Wal-Mart's case, insiders and members of founding families).

One final observation: In 1965, long before he entered the public debate on taxation, Warren Buffett described his philosophy toward taxes this way: "It is going to continue to be the policy of [Buffett Partnership Ltd.] to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury--at the lowest rates the rules will allow." Though Mr. Buffett's more recent and more public views on federal tax policy have attracted plenty of attention (and no shortage of critics), it's hard to argue with the logic he expressed as an investment manager almost 50 years ago.

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