A tale of rising dividends and falling profits!
(Jun 16, 2015)
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In this issue:
» Beware of the most common mistake in investing!
» China's leveraged stock market boom reaches precarious levels!
» Round up on the markets
» ...and more!
A few days ago, we had written about the dividend bonanza enjoyed by shareholders of some stocks. These were mostly stocks backed by strong company fundamentals. Being value investors, the dividends are an important factor when we select stocks. A regular dividend payout history is a clear sign of a fundamentally sound company. While earnings can be manipulated by creative accounting, dividends cannot be as it is a cash transaction. However, we don't recommend that you fill up your portfolio with high dividend stocks. There is more to this story.
Dividends are supposed to be a sign of confidence that the management has in the business. It is a sign that the business is throwing off excess cash. To quote Warren Buffet; "Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally" . Thus, if a business generates cash greater than its internal needs, we believe the management should return it to shareholders. The key issue is how this is done.
Many firms have a stated dividend policy. The annual report may state the percentage of profits the company will pay out. If the board of directors increases the dividend, it should imply that profits too have increased. However, we came across an article in the Economic Times that found the opposite to be true! 20% of companies that were analysed increased dividends despite a fall in the bottomline. If you own shares in such a company, should you be worried?
We believe the answer can be found only by digging a little deeper. The following questions should come to your mind. Was the profit decline only due to a one-off event? Is the business generating strong operating cash flow as before? Is the management struggling to find growth opportunities? Has debt been taken to fund the dividend payout? Unsatisfactory answers to these questions should ring alarm bells.
Keep in mind that the best dividend paying firms usually have a few things in common. Solid underlying businesses, shareholder friendly managements and strong operating cash flows are the most important ones. If this is not the case with the stocks that you own, you should not take the management's positive views at face value. It could be a case of promoters enriching themselves via higher payouts.
However, a temporary fall the net profit may not necessarily be a cause of worry. For example two of the companies listed by the financial daily, Bajaj Auto and Mahindra & Mahindra, had a challenging year in FY15. However, these businesses have a strong historical track record which investors will have to factor in. So while dividends are important, we believe it should only act as a starting point for your analysis. Dividends are not an end in themselves. What really matters is the state of the business that generated it. As is the case with most things in life, dividend investing is not as simple as it appears to be!
Do you invest primarily for dividends? What do you look for in such stocks? Let us know your comments or share your views in the Equitymaster Club.
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As the monsoons and earnings put a reality check on investor's expectations, the benchmark indices have witnessed some correction since their life time highs. And this we believe could be a great time to pick up fundamentally strong stocks for investors that have a long term horizon.
However, what seems to be an opportunity could turn out to be disaster if you get the concept of value investing wrong. Allow is to explain. We often come across queries and feedback that suggest that a particular stock is cheap and worth considering for recommendation as it is trading significantly lower than its 52 weeks high. We believe that nothing could be farther from truth. To decide whether a stock is trading cheap or expensive on the basis of absolute price is fallacious. After all, price is just a part of the equation. By itself, it is not enough to decide if a stock is trading cheap or expensive. Ideally, what you should be looking for is fundamentally strong stocks trading below their intrinsic value. If you ignore the former, chances are that you will end up with stocks making even new lows.
Does the recent correction imply a buying opportunity?
There seems to be a dichotomy between Chinese markets and economy. While the latter is struggling for growth, the market valuations suggest a different story. With real estate market cooling down, investors seem to have turned to stock markets.
However, as suggested in an article in Economic Times, there is more to what is driving the stock market boom amidst uncertain economic climate. The investors have not just put their savings at stake, but are using borrowed money to invest in markets. There has been a five times increase in margin lending, wherein brokerage firms lend money to investors to buy stocks. Further, it is expected that the total amount borrowed is even higher, including the amount borrowed from family and banks.
This puts to risk not just the stability of household finances, but the entire financial system. Especially because it seems that it is the stocks of small and relatively lesser known firms where investors are putting money in hope of quick gains. This is indeed a precarious situation. Unfortunately, if things go wrong, it won't be just China's problem. Considering the money that has poured into these markets from other economies, the consequences could be far reaching.
After opening the day in the red, the Indian stock markets moved into the positive territory. At the time of writing, the BSE-Sensex was trading higher by 100 points (+0.4%). Barring oil and gas, FMCG and realty, all sectoral indices were trading in the green with stocks in auto and consumer durables leading the gains.
"A public-opinion poll is no substitute for thought." - Warren Buffett
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|This edition of The 5 Minute WrapUp is authored by Richa Agarwal (Research Analyst).
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