These Dividends Are Nothing Special

Now more than ever, investors are paying close attention to stocks that pay dividends. But when you evaluate a dividend announcement from a company, you have to remember that the only thing a dividend does is move money from the company to its shareholders.

That's why the attention "special" dividend announcements get often makes little sense. Unlike regular dividends, the primary purpose of most special dividends is simply to soak up excess capital. Buying into companies that make such payouts at highly inflated prices is a short-sighted move that can cost you in the long run.

Understanding dividends
The idea behind regular dividends is pretty simple. Profitable companies regularly earn more money than they spend on their regular operations. Faced with excess capital, companies can either reinvest that capital into their business, use it to invest in new business opportunities, or return the capital to their shareholders. Typically, dividend-paying companies do a combination of all three, retaining some of their earnings for internal reinvestment but giving shareholders a piece of the profits in the form of dividend payments.

Investors like dividends because they typically indicate that a company believes it will generate enough cash to make those payouts on an ongoing basis. Although a company has no obligation to continue paying dividends, companies that cut or stop paying a dividend entirely have such a negative stigma attached to them that most companies avoid it if at all possible. Similarly, when a company raises its dividend, investors see it as a sign of improving future prospects for their stock.

Special dividends, on the other hand, happen for very different reasons. Sometimes, they occur in connection with some one-time event in which a company receives a large chunk of money. In other cases, companies decide to pay a special dividend simply to rid itself of excess cash for which it has no other use.

Compared to regular dividends, which are typically only a few percent of the stock's price, special dividends can be huge. Here are some of the companies that have declared or paid special dividends recently:

Reactions to these announcements vary widely. Diamond Hill shares, for instance, jumped more than $11 the day it announced the special dividend. Weyerhaeuser saw a much more modest jump of $3 when it announced its plans. Valeant, on the other hand, saw little movement resulting from its announcement.

Of course, the reason for the announcement makes a big difference in how investors will take the news. Valeant, for instance, announced the distribution in connection with its recently completed merger with Biovail (NYSE: BVF). Weyerhaeuser paid the dividend to comply with tax laws governing its conversion to a real estate investment trust. In contrast, Diamond Hill's distribution will be the third such special dividend in three years.

For smaller distributions, special dividends often resemble regular dividends. Daktronics, for instance, cited an accumulation of cash, along with its belief that future cash flow would replenish its balance sheet. PDL Biopharma has made several special dividend payments since 2008, while for Life Partners, the special dividend simply doubles its regular dividend payment for the quarter.

Don't pay up
What's most important to understand, though, is that there's no free lunch from buying shares of companies that have declared special dividends. On the date specified as the ex-dividend date, shares will likely drop by an amount very close to the special dividend payment. For instance, when Weyerhaeuser paid its dividend, it fell from almost $42 per share to around $16.

In fact, buying before a special dividend can cause problems. Depending on the tax treatment of the dividend, you may end up paying taxes on the amount you receive, even though your shares will fall in value by a similar amount.

As important as dividends are for investors, don't get caught up in the hype around special dividends. There's no reason to pay premium prices just to get the money you paid for your stock right back in the form of a dividend.

Regular dividend growth is definitely a good thing. Todd Wenning and Bryan Hinmon have found five top stocks for dividend growth.