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Dividend stocks - An investment case - Views on News from Equitymaster
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  • Jun 7, 2004

    Dividend stocks - An investment case

    Dividend - the dictionary meaning of this word is ‘resultant return or reward'. While this word can be used in various contexts, here we are talking about it in the stock market parlance. In this context, the word can be described as ‘a reward (cash) received by an investor for investing in the stock of a particular company'. This reward, announced by the board of directors, is based on the profitability of the company. Dividend is calculated as a percentage of the face value of shares and is distributed amongst the shareholders. While in a true sense, dividends are the returns investors enjoy for their faith in a particular company's prospects, thanks to various policy measures, practices like dividend stripping are rampantly prevalent. However, we shall not concentrate on such issues in this article, rather we will consider a case for investing in high dividend yield stocks.

    Equities by their very nature are a high-risk investment option. But the relatively higher returns, more often than not, adequately compensates an investor for this risky venture of his. However, in equity investments, high yield dividend stocks are relatively safer for investors who have a lower risk taking appetite and for whom, preservation of capital is largely of prime importance. However, investors must understand that this does not mean that high dividend yield stocks are averse to capital erosion, but the downside is generally capped for reasons discussed later.

    Before we look at how is an investment relatively safer when invested in dividend paying stocks, let us look at how to calculate the dividend yield of a stock. It must be noted that dividend yield is calculated as a percentage of market price of that stock, while the absolute dividend declared is a percentage of the face value of the share. See the example below:

    Infosys Reliance Satyam Grasim GE Shipping PNB Gilts
    Price as on June 4, 2004 (Rs) 5,219 434 309 1,040 117 24
    Face vale (Rs) 5 10 2 10 10 10
    FY04 dividend declared (%) 590% 53% 200% 140% 65% 25%
    Dividend per share (Rs)* 29.5 5.3 4.0 14.0 6.5 2.5
    Dividend yield (%) 0.6% 1.2% 1.3% 1.3% 5.6% 10.5%

    * Excluding one-time special dividend in case of Infosys

    As can be seen in the table above, while the dividend declared by Infosys, both in terms of absolute dividend per share and also in terms of percentage, is way ahead of the others, its dividend yield is the lowest. Thus, it is not the absolute dividend that should be considered but rather than dividend yield that would make a difference as your total investment is total units multiplied by the share prices and not the face value of the stock. In order to understand the importance of dividend yield, consider the example below:

    Infosys Reliance Satyam Grasim GE Shipping PNB Gilts
    Amount invested (Rs) 10,000 10,000 10,000 10,000 10,000 10,000
    Shares purchased (approx. units) 2 23 32 10 86 422
    Total dividend received (Rs) 57 121 130 135 556 1,055
    Return on investment (%) 0.6% 1.2% 1.3% 1.3% 5.6% 10.5%

    Another advantage of having fundamentally sound dividend stocks in one's portfolio is the fact that these tend to be relatively stable vis-ŕ-vis the markets and a considerable fall in prices of these stocks is unlikely compared to those which the markets fancy. This is primarily because during times of falling prices, the dividend yields of these stocks become very attractive. As a result of this, the downside in these stocks is limited until and unless there is something seriously wrong with the fundamentals of the company. Moreover, these stocks tend to appreciate with the general markets, though the rise may not be very spectacular. Thus, dividend stocks are a good option for investors with lower risk taking ability and who prefer a steady income with a ‘possibility' of capital appreciation.

    However, from an investors' point of view, the ‘total return' on the stock is more appropriate as compared to only the capital appreciation or only the dividend. This is because it is quite possible that that the gains from dividends is more than negated by the fall in the stock price. Considering this factor, below is an example wherein 7 stocks have been selected at random and the total returns arrived at.

    Worth a look...
    30-Mar-01 31-Mar-04 Appreciation^ Dividend* Total Returns (CAGR)
    BSE Sensex 3,604.4 5,590.6 15.8% NA NA
    Dividend stocks
    PNB Gilts 17.3 25.6 14.1% 8.2 22.9%
    GE Shipping 26.8 127.0 68.0% 17.3 74.2%
    LIC Housing Fin. 30.1 182.6 82.5% 20.0 87.7%
    Blue Star 31.8 141.5 64.5% 30.0 73.5%
    Index heavyweights
    Infosys 4,082.9 4,938.2 6.5% 86.5 7.1%
    HLL 218.8 154.3 -11.0% 17.0 -8.5%
    Reliance 390.9 538.1 11.2% 19.3 12.3%
    ^ CAGR capital appreciation since March 30, 2001 to March 31, 2004
    *Total dividend declared in the 3 years under consideration excld. special one-time dividend, if any

    It must be noted that after a company declares dividend, the stock goes ex-dividend i.e. the stock price tends to fall by as much as the dividend declared. This is because the dividend is declared from the companies' profits and thus reduces reserves. Healthy dividend declarations are a good sign indicating that the company believes in sharing profits with the investors and is also confident of growing year on year. However, the negative implication of healthy dividends could be that the company is unable to find suitable opportunities within the company or outside, where the money could have been invested for better returns. Now, while there can be more arguments on both the fronts i.e. dividend paying and non-dividend paying companies, the above table is in a sense an indication of the advantage of divided-based investments. Compare the returns with your fixed deposit returns or any other government instrument and the picture gets much more clearer.

    FY04 dividend stocks

    However, investing in a dividend story is not just about the dividend yield and the dividend history of the stock. It is also about the fundamentals of the company, its management and the business model. The dividend history of the stock is a good indicator of future dividend declarations by the company. However, an investor must remember - there is always a possibility that the dividend declaration trend might not continue or dividends may be curtailed down if the company fails to maintain its performance. But, part exposure to high yield dividend stocks is always likely to assure the investor of a steady income irrespective of the stock market movements. Dividend stocks may not give astounding returns within a short span of time, but they definitely provide some kind of a hedge against the day-to-day volatility witnessed amongst stocks that are darlings of the market.

    To sum it up, high dividend yield stocks could give investors the best of both worlds. If the stock prices surge, the gains would be in the form of capital appreciation. If not, the investor gains from the dividends declared by the company. In conclusion, part exposure to high yield dividend stocks is always likely to assure the investor of a steady income, not to forget the built in upside surprise element!



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