Investors, Keep Your Cool About Special Dividends

NEW YORK ( TheStreet) -- The plot thickens in the race for companies with excess cash to distribute a portion of that bounty to shareholders in the form of special dividends.

Fearful that a deal won't be reached to avert the fiscal cliff and prevent the tax rate on dividends from jumping, these companies are opting for the certainty that shareholders won't pay more than 15% in taxes on qualified dividends in 2012.

On Monday I wrote about this subject in "Lemmings Grasp Special Dividends Ahead of Fiscal Cliff."

During the past few days more names have joined the special dividend party, and this just added to the curiosity of this "mini-phenomenon." I call it that only because the market's reaction to some of these announcements has been very interesting.

For instance, after the close of Monday's trading, Electro Scientific Industries ( ESIO), which I've owned for a few years, announced that it will be paying a $2.00 special dividend. The company certainly has the liquidity to make this move, having ended its' latest quarter with nearly $195 million, or $6.63 per share, in cash and short-term investments. In fact, the dividend, which should total about $59 million, will still leave the company with more than $136 million.

ESIO Cash and ST Investments Chart ESIO Cash and ST Investments data by YCharts

What was so surprising was the market's reaction to ESIO's announcement. Shares rose more than 10% at the opening and finished the day up about 6.5% on more than four times the average volume. This was all because the company is forking over some cash to shareholders.

Although I'm happy whenever a stock I own jumps 6.5% in one day, the reaction makes no sense. Perhaps current shareholders are happy to have some cash returned to them, but why would this announcement, by itself, attract any new buyers?

ESIO Chart ESIO data by YCharts

When a company pays a dividend, it is transferring capital back to shareholders, capital the company will no longer have access to. In the case of the one-off special dividend, some people interpret these payments as a signal that the company has no better opportunities for using that cash and generating a reasonable return on capital. As much as shareholders love cash in their pockets, they also want to know that the companies they own can find opportunities to grow their businesses.

In theory, once a stock trades ex-dividend, its price should adjust downward to account for the dividend. We rarely notice this adjustment with ordinary dividends, because the dividend amounts are relatively small, and the adjustment is often obscured by other factors affecting the stock.

But with the size of some of the special cash dividends, you should see a noticeable decrease in stock prices on the ex-dividend date. In Electro Scientific Industries' case, all else being equal, this will be a $9 stock ex-dividend. (Shares were trading Wednesday morning at $11.36, up 15 cents on the session.)

All the fervor about these special dividend-paying stocks and the price jumps due to the dividend announcements suggest to me that there is a new inefficiency being created, and that there is money to be made on the short side of the equation.

I am not a short-seller, but those who are may have found a new way to exploit this potential inefficiency over the next couple of weeks. Find a stock that jumps purely due to a special cash dividend announcement; if the market appears to overreact to the plus side, there may be opportunity. Certainly not my cup of tea, but I would not be surprised if it's already being done.

At the time of publication, Heller was long ESIO.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Jonathan Heller, CFA, is president of KEJ Financial Advisors, his fee-only financial planning company. Jon spent 17 years at Bloomberg Financial Markets in various roles, from 1989 until 2005. He ran Bloomberg's Equity Fundamental Research Department from 1994 until 1998, when he assumed responsibility for Bloomberg's Equity Data Research Department. In 2001, he joined Bloomberg's Publishing group as senior markets editor and writer for Bloomberg Personal Finance Magazine, and an associate editor and contributor for Bloomberg Markets Magazine. In 2005, he joined SEI Investments as director of investment communications within SEI's Investment Management Unit.

Jon is also the founder of the Cheap Stocks Web site, a site dedicated to deep-value investing. He has an undergraduate degree from Grove City College and an MBA from Rider University, where he has also served on the adjunct faculty; he is also a CFA charter holder.

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