The Dividend Month Premium and Paradox
Just before a stock's dividend cut-off date, buyers far outnumber sellers, which defies the logic of the stock market. What's going on?
There are large abnormal returns that investors receive in months when companies are predicted to pay dividends — about 40 to 50 basis points, half a percentage above what risk factors would predict in that month. Paradoxically, experienced investors are not taking the expected position of shorting the stock and selling when others are buying. Equally puzzling, investors looking to collect on dividends are delaying share purchases until the final possible day, depriving themselves of larger returns, according to co-researcher David Solomon of University of Southern California. Solomon presented his findings at the Queen's School of Business annual Behavioural Finance Conference.
“Do you know the only thing that gives me pleasure? It's to see my dividends coming in.” — John D. Rockefeller
Many investors over the years have shared Rockefeller’s lust for dividends. Lust makes people do crazy things, though it can hardly explain some uncharacteristic investor behaviour during the period of stock trading related to dividend payouts.
In the tumultuous and uncertain world of stock market traders, the dividend cycle runs like clockwork, or close to it. Publicly-traded companies that issue dividends generally do so on a fixed schedule: there is a declaration date on which the company announces when the dividend will be paid; the in-dividend date, the final day investors can purchase shares and receive the dividend; and the ex-dividend date, defined as the first day following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment.
This dividend cycle is a focus of demand for investors who want to purchase company shares just before the dividend cut-off date and for investors who want to sell off to avoid collecting a dividend. According to the logic of the stock market, any surge in demand and rise in stock price should be offset by other investors “shorting” the stock.
But in reality, something else is happening, says David Solomon, assistant professor of finance and business economics at Marshall School of Business, University of Southern California. Buyers far outnumber sellers, leading to price increases around the periods when companies issue dividends. He and fellow researcher Samuel Hartzmark call the phenomenon the “dividend month premium.”
“There are large abnormal returns that you can get as an investor in months when companies are predicted to pay dividends,” says Solomon, who presented a paper during the Behavioural Finance Conference at Queen's School of Business in May 2012. “On average, those months [when companies issue dividends] have big returns. You’re clearing about 40 to 50 basis points, half a percentage extra over and above what the risk factors would predict in that month. The dividend event seems to generate these high returns.”
Little market correction
What about market efficiency? For one reason or another, arbitrageurs are not taking the other side of the trade, says Solomon. There is stock price pressure on the day the dividend is announced, a price increase on the ex-date, and even price pressure in the period between.
“Why aren’t the smart guys doing what we think they should do, which is to sell when the other guys are buying and buy when the other guys are selling and make the price even out?” Solomon asks. “One of the bits of evidence we see suggests that the smart guys are doing the opposite. They’re trying to front run the effect” — buying just before others buy and selling just before others sell.
“It seems to suggest that you can’t always rely on the smart guys to correct predictable demand. They may find it more in their interest to try and ride this wave of investor demand rather than correct the wave of investor demand.”
Research by Solomon and Hartzmark presents another paradox. The price surge just before the ex-date suggests that investors are gobbling up shares at the last moment to get in on the dividend. The question is, Why are they waiting to the last day instead of buying shares earlier, say before the dividend declaration date or on the declaration day? “If you wait until the last day, you’re missing out on a large number of abnormal returns,” says Solomon. “You’ll probably clear an extra 30 basis points.
“It’s not clear what the answer is. It could be they don’t know about it, or there may be portfolio reasons that they hate holding the stock more than they have to.”
That’s certainly not a decision John D. Rockefeller would make.
— Alan Morantz