Why We Do Not Recommend All High Dividend Stocks... - The 5 Minute WrapUp by Equitymaster
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Why We Do Not Recommend All High Dividend Stocks...

Oct 19, 2016
In this issue:
» India is a laggard in mutual funds penetration
» Asset sales are picking up pace
» ...and more!
00:00
Radhika Pandit, Managing Editor of ValuePro

When we recommend stocks for ValuePro, a main criterion we look for is dividends. Typically, the payout ratio has to be more than 20% for a stock to come under our radar.

But that does not mean we recommend all high-dividend companies. And here's why...

For one, the payouts have to come from the company's profits. This means that business should generate sufficient cash so that, after accounting for capex, enough is left to be paid as dividends.

The implication here is that, yes, some companies borrow to keep their payout ratio high. This strategy is hardly sustainable. Indeed, we really do not want companies to take on debt to pay their dividends.

You see, if a company has the ability to generate healthy cash from operations for a period of say eight to ten years, it means it has a strong business model with many competitive advantages. And only such a company can maintain high dividend payouts. So we typically shortlist dividend-paying companies whose debt-to-equity ratio has been less than one in the past.

We also look at the dividend yield. This is just the dividend per share divided by the share price of the company. It gives us an idea of the valuations the stock is commanding. A stock with a dividend yield of 2-4% makes for an ideal candidate. If you look at some of Warren Buffett's top stocks - Coca Cola, IBM, and Wells Fargo, for example - they enjoy dividend yields in that range.

Sometimes, the dividend yield is attractive because the share price is quite low. If that's the case, we want to know why the stock price has been beaten down so much. Is it a fundamental problem with the business? Because if it is, the stock price may not recover for a long time. And so the high dividend yield may not carry much weight.

We have recommended ValuePro subscribers a healthy mix of companies that pay good dividends, have strong business models, and are in the pink of health financially. Some don't pay as high dividends as the others. But that's only because they are more capital intensive and growing faster.

Remember, while a company's dividend is a very important criterion to shortlist stocks, it must be considered in conjunction with other factors. A high dividend will never be the sole reason we recommend a stock.

03:01 Chart of the day

Mutual Fund (MF) penetration in India remains woefully low. A 7% share of Assets under Management (AUM) of MFs to GDP is abysmally low as compared to double digit shares enjoyed by developed economies such as US, UK and Japan. The penetration is even lower than that enjoyed by emerging economies such as Brazil and China. Moreover, swift regulatory changes being introduced by Securities and Exchange Board of India (SEBI) in the last few years is also not helping the industry.

In a latest move, SEBI has proposed an amendment that seeks to segregate advisory from the distribution function. Under the new amendment, MF distributors who want to give advice would be required to become registered investment advisors (RIAs) within three years.

Although the advisory model heralds the future of MF industry as it curbs mis-selling, it is yet to catch on in India. The sole reason being that MF investors in India are still not willing to pay for advice separately. While this evolution will take place gradually, the regulatory push can have an adverse impact on the industry if a large number of distributors are not able to migrate to being RIAs. There is also a lingering fear that intermediaries may consider shifting to other financial products where they can offer advice as well as distribute. The MF distribution community is already fighting against the regulatory requirement of disclosure of commissions received by them in the account statements sent to investors.

While the amendments are likely to usher in greater transparency in the MF industry but care should be taken in implementing them to ensure a smooth transition without affecting industry growth.

India a Laggard in Mutual Funds Penetration


04:02

Banks struggling with bad loans have some reason to cheer. Highly leveraged Indian companies have sold off assets worth Rs 1.5 trillion since the start of 2016. These include the Essar-Rosneft deal of Rs 861 billion, Jaiprakash Industries sale of cement units for Rs 183 billion and Reliance Communications' 51% stake sale in tower business at Rs 110 billion.

Asset sales are likely to result in higher repayment of debt. Moreover, as new owners with better credit ratings take over the companies, it will also bring down the level of stressed assets in the Indian banking system. The gross bad loans of the banks stood at Rs 6.3 trillion as on 30th June 2016. Banks, on their part, are also supporting these transactions for debt resolution. SBI is working with 10-15 stressed accounts that are being targeted for resolution by 2018. For a speedy debt recovery under the scheme for Sustainable Structuring of Stressed Assets (S4A), RBI is working on dilution of the requirement of the sustainable portion of the debt being at least 50% and allowance of future cash flows for debt servicing.

Although debt resolution in India Inc has gathered pace but its impact will be felt in some time as issues such as shareholding, taxation and court approvals also need to be addressed.

04:45

After opening the day flat, Indian equity markets slipped below the dotted line. At the time of writing, BSE Sensex was trading lower by 103 points and NSE-Nifty was trading lower by 33 points. Each of the mid cap and small cap indices are trading higher by upto 0.4%.

04:56 Today's investment mantra

"A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Madhu Gupta (Research Analyst).

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