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For those who want to invest in the right stocks - Views on News from Equitymaster
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  • Sep 13, 2010

    For those who want to invest in the right stocks

    Dividends. We don't think there is any other concept that has lost as much relevance over the decades as dividends. Indeed, from being the lynchpin of investors at the turn of the century, most investors only make a passing reference to dividends these days. Gone are the days when the entire valuation of the company used to rest around its dividend payout.

    These days, it is the other way round. For investors used to growth style of investing, dividend is nothing short of being evil. Dividends, they argue are paid by companies that have nothing productive to do with their surplus cash. Infact, when calculating total returns from a stock, only the capital appreciation is taken into account. Dividends, at best, get only a passing mention in the coverage of majority of the stocks.

    However, not all investors consider dividends as a waste of time. And you can surely count us to be a member of that diminishing tribe. We believe that dividends still offer as much value as before if not more. One only has to know how to use it as an important analytical tool. This write up aims to explore some of the important stuff with respect to dividends:

    We have observed that a company that grows fast but does not maintain a dividend payout or fails to increase its dividends per share is showing signs that something will or has gone wrong with the business.

    Do a small study if you wish to. Try and find out the companies that have fared the worst over the past few years. There is every chance that bulk of the companies on the list will be the ones that have either reduced their dividend payouts for an extended period of time or have not paid them at all.

    During boom times, capital is available in plenty. Hence, lot of companies can borrow cheap and thus, raise their earnings. But earnings growth based on continuous fund raising is not sustainable. No sooner will capital availability diminish, the company will also cut its dividends.

    Also, dividend is a completely objective parameter. One can certainly manipulate earnings growth by resorting to accounting gimmicks. But the same cannot be done with dividends. Thus, if a company claims to grow its earnings handsomely but does not do the same with dividends, a more detailed look into the company's affairs is indeed warranted.

    The second advantage with respect to the objectivity of dividends is that it can be used to time one's entry into a stock more correctly. When buying stocks, people look at P/E or P/BV. However, going forward, it would also help if the dividend yield is also taken into account. We believe buying a stock after ascertaining that its trading at a dividend yield of 3%-4% could certainly give you better returns than buying based on just P/E or P/BV. After all, there are chances that earnings or book value are inflated due to certain onetime changes. Thus, having a cushion of a decent dividend yield indeed helps to make sure that we are not paying more for stocks than warranted. Also, please check out whether 3%-4% dividend yield is not due to a onetime special dividend and any similar such thing.

    Another advantage with dividend yield is that it can also be used to find out whether the broader stock market is overvalued or not. Here also, there are various competing tools like market P/E, market P/BV or market cap to GDP ratio. But we believe that it is the objectivity of dividends that yet again gives it the edge. Studies have shown that entering into the stock market when overall dividend yields are trading at record highs, proves quite rewarding from a 2-3 year perspective.

    Thus, as we have seen, dividends by no means can be looked down upon. They can indeed come in handy while picking the right stocks in one's portfolio. Investors ignore them at their own peril.



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