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Investors, Keep Your Cool About Special Dividends

Tickers in this article: ESIO

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 ChartESIO 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 ChartESIO 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.)