What does dividend stripping mean?

‘Dividend stripping’ traditionally has been a popular strategy with active investors, looking to generate franked income via the purchase of physical shares prior to a declared dividend being paid by a company.

The strategy is usually implemented by buying the shares several weeks before the ex-dividend date on the premise that shares often rally as this date approaches as investors look to capture dividend cash-flow.

On the day the company trades ex-dividend, theoretically the share price drops by the amount of the dividend. However, quality companies, such as the Australian banking sector, historically recover the value of the dividend within a matter of weeks, at which time they can be sold at a potential profit.

If an investor holds the shares of a company for more than 45 days (not including the day of purchase or sale), they can claim a tax credit equal to the amount of corporate tax paid by the company. A further qualification of franking is that holders must retain a delta of not less than 30% of the risk of the shares. In other words, investors cannot hedge more than 70% of their exposure via the use of equity derivatives such as traded options or Contracts for Difference (CFDs).

Share trading has been the traditional method of ‘dividend stripping’. However, the recent growth in popularity of trading on margin using CFDs has provided investors with a means of potentially increasing the attractiveness of ‘dividend stripping’ due to the leveraged nature of share CFDs.

Sound fundamentals and strong yields have made the banking sector attractive to ‘dividend strippers’ over the years. For example, Commonwealth Bank of Australia announced a $1.07 per share dividend to go ex on 19 February 2007. An investor could purchase the stock two weeks before the ex-date, 5 February 2007, at $50.40. On 21 February 2007, just days after collecting the dividend, the stock could be sold for $50.51, a total profit of $1.18 per share including the dividend. The stock rallied considerably in the two weeks leading up to the ex-dividend date so an alternative was to close the position before the ex-date at $51.81, realising a capital gain of $1.41 per share.

There are two key factors to successful trading through ‘dividend stripping’. As with all investment strategies, knowing when to enter and planning when to exit is paramount to profitable trading. Also, choosing sound companies which historically increase dividend distributions year-on-year is important. This will make rapid price recovery from dividend payment more likely, an integral part of ‘dividend stripping’.

However, a note of caution: in recent times, the share market has been particularly volatile, making ‘dividend stripping’ less attractive. Also any form of leveraged trading carries a certain amount of risk.