Are high dividend stocks always safe?

Dec 7, 2010

In this issue:
» Realtors look for alternate sources of funding
» Employment growth visible in emerging markets
» Food prices to surge by 2050
» India needs a second green revolution
» ...and more!!

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Growing economic uncertainty in the world and the recent spate of scams in India has investors worried. In light of the scams especially, the importance of good corporate governance is being felt like never before. And so investors are making a beeline for stocks in the large cap space. The perception being that these companies have better disclosure practices. And so the probability of scams erupting in this space is much lesser than in either the midcap or small cap space. What has also enthused investors is the steady income that these companies offer by way of dividends. The fact that dividend income is tax free in the hands of investors is an added advantage. And so many investors are lapping on to stocks where the dividend payout is good even though the valuations are expensive.

But this may not be such a wise move. We believe that investors need to look at dividend yield of companies while investing in their stocks. Dividend yield is nothing but the company's dividend per share divided by its stock price. Thus, even if the dividend paid out is good, if the stock price is very high, the yield will not be that great. At the end of the day, when investing in equity markets, an investor has to look at two factors. One is the benefits of capital appreciation. The other is the dividend yield. The two combined would constitute the total return that would accrue to an investor. And this return will not be strong, if the stock price of any company is disproportionately high. Thus, strong corporate governance, good growth prospects and a healthy dividend policy are certainly prerequisites for investing in equities. But always keep an eye on valuations too.

 Chart of the day
Cities in the emerging economies have done pretty well in 2010. Along with growth in incomes, most of these cities have reported a strong growth in employment as well. As today's chart of the day shows, employment growth in cities of Brazil, India and China is miles ahead of those in the developed world. Infact, cities in the US and Europe are still grappling with the problem of rise in unemployment. Truckloads of stimulus measures have not done much in terms of easing unemployment pressure in the developed world.

Data Source: The Economist

There are a lot of ways in which businesses can be classified. One amongst them is by way of capital intensity. There are capital intensive businesses and then there are non capital intensive businesses. Where, according to you would real estate fall? We believe it will fall firmly in the former camp. Indeed, there are very few businesses on the face of this earth that are as capital intensive as real estate. Companies in this space enjoy very good margins no doubt. But by the time one of their projects finishes, land prices go up so much that all the extra profits that they have earned, have to go into new projects. And if a company is too ambitious and is working on too many projects at a time, then of course, there is no other option but to go in for a lot of debt.

This is the exact predicament that a lot of real estate companies in India are facing right now. So far, the big players had little or no difficulty in getting their loans sanctioned by banks. But not anymore. The authorities have tightened the noose around banks that were lending freely to real estate companies. And as a result of this, funding from banks for realty has become very hard to come by.

A leading daily reports that in order to circumvent this problem; realtors are now turning to PE firms and NBFCs for fund raising. And while currently these institutions seem to be welcoming realty with open arms, we believe it will not be long before they too learn the flip side of investing in real estate businesses. An industry and a capital intensive one at that cannot survive for long if affordability is a big question mark for most of its buyers.

India has of late warmed up to environmental concerns. So much so that even the most high profile projects have received notices for lack of clearances. The effort is indeed noteworthy. We do not say this because Indians are seen toeing the line of their developed peers. But also because in our thirst for growth, we should not become the largest carbon emitter in the world like China. But the fact remains that India needs growth to sustain for it to remain environment friendly. A fancy real estate project may not be of much significance to the economy's progress. But embargo on power and mining projects could certainly shrink the growth rate. So much so, that even the foreign funds finding their way into the economy may stop if they are not utilized on time. Indian politicians have kept several important FDI linked projects on paper for years now on the pretext of environment clearances. Unless the issues are resolved quickly, we may see a flight of FDI from the infrastructure financing space. And unfortunately that could seal the fate of our economy for a very long time!

Feeding over 9 billion hungry mouths by 2050! Mother Earth surely has its work cut out. Changes in global temperatures and rainfall patterns are a huge cause of concern. Growing populations and higher income levels are also adding to this recipe for disaster. Food grain prices are expected rise between 31-101% globally by 2050. Supply side factors are the main cause of this price pressure. India has a large percent of its population living below the poverty line. Food subsidies are what help sustain this large segment. The government needs to look very closely at these issues. Managing food security, inflation and climate change are primary concerns. Without these in check, other growth rates have no meaning.

Here's another one on food. The food crisis is looming large. And so, agriculture is back in the spotlight. After years of disregard it seems we have come full circle. India's first lady has voiced the need for a second green revolution to feed the country's poor. Indeed agriculture needs to be developed with urgency for a myriad of reasons. Growth in agriculture is two-three times more effective in raising the incomes of the poor. There is a strong need to improve farm productivity and to also strengthen the distribution network. The President has asked the industry to seriously look at the food processing sector as an investment option. The processing level of agricultural crops is currently very low. The farm sector needs to have linkages with other sectors of the economy. Only then can inclusive growth become a reality.

Global demand for oil has been stronger like never before. But this trend has not really come into the limelight as other topics such as Europe's debt woes and the surge in gold grabbed headlines. And this rise in demand for oil has mainly come from emerging markets. Obviously, economic growth in emerging economies such as India and China has been quite strong and this has also spilled over to demand. Global oil consumption has bounced well off early 2009 lows. It is now above pre-crisis consumption levels.

Moreover, demand for oil in the developed world has largely remained stagnant for the past 18 months. And in the emerging markets this has surged. As a result, usage gap between the two has narrowed to 4 million barrels per day currently which was about 12 million barrels per day in 2007. Other factors that will drive the demand for oil especially from emerging markets are the increase in population and the fact that fuel is subsidized. All this on the demand side. On the supply side, the OPEC will find it difficult to increase production given that its spare capacity has already peaked. All this points to higher oil prices from a long term perspective.

At the time of writing, the Indian stock market were trading in the red as selling pressure increased during the post noon session. Stocks from the realty and banking sectors were amongst the top losers, while those from the IT and oil & gas sectors were the top performers. As for rest of Asia, markets ended on a mixed note with China and Hong Kong ending higher by about 0.4 to 0.7% and Japan ending lower by about 0.3%.

 Today's investing mantra
"In both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult." - Warren Buffett

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2 Responses to "Are high dividend stocks always safe?"


Dec 7, 2010

very confused



Dec 7, 2010

My post pertains to "Food prices to surge by 2050".

I am a regular reader of 5 minute wrapup. Its an useful offering from Equitymaster. You have mentioned "Food grain prices are expected rise between 31-101% globally by 2050." I totally disagree on this. Though its a future event, i strongly beleive that considering inflation and the food price raise over the last 10 years, the food price will rise above 400% by 2050.

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