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Your insurance against stock price volatility - Views on News from Equitymaster
 
 
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  • Dec 12, 2011

    Your insurance against stock price volatility

    We are three weeks away from the end of 2011. But, how have your portfolios fared so far this year? The year started off with a lot of promise. Markets were at their peaks at the beginning of 2011 but this excitement quickly fizzled out. The Indian stock markets and the rupee have both gone south in 2011. GDP growth in the country has slowed and global uncertainty is still looming. All this bad news would certainly have had an impact on your portfolio. Unless, you had stayed invested in a certain category of stocks. This could have been your insurance plan against stock market volatility seen this year.

    Companies have four major ways in which they can use their excess cash. They can either make headline grabbing acquisitions. Or they can buy back their shares from the public. They can either sit on their cash nest or they can reward their shareholders in the form of dividends. But, acquisitions are risky, and sitting on cash is unproductive. Thus most companies either opt for buybacks or paying out dividends. We shall focus on the companies which do the latter in this article. Thus even in case of a fluctuation in the share prices, investors can benefit from the yearly dividend cheque they receive from these companies.

    Warren Buffett, one of the world's most successful investors practices this method of investing. His key investments Wells Fargo, Coca Cola, and American Express all exhibit similar characteristics. They all have strong competitive advantages in their respective fields making them strong value picks. But, they also have something else in common. They are able to generate large amounts of free cash flows and pay it out to their investors in the form of dividends.

    Now let's take a closer look at a few companies in the Indian stock market that are strong dividend payers:

    Company Name Dividend yield Increase in dividends
    (5 yr CAGR)
    Increase in earnings
    (5 yr CAGR)
    Hero Motocorp 6.6% 39% 15%
    HPCL 3.9% 31% 30%
    Ashok Leyland 3.5% 11% 12%
    REC 3.0% 31% 26%
    ACC 2.8% 31% 16%
    Source: Ace Equity

    We looked at the BSE-100 index as our universe, and shortlisted the above stocks based on high current dividend yield. We made sure that these stocks showed a positive trend in increase in dividends as well as earnings over the past five years.

    Most companies in the list above have shown an in-tandem increase in both earnings as well as dividends paid out. However some like Hero Motocorp and ACC have been overly generous.

    Hero Motocorp has been extremely generous in doling out dividends to its shareholders, out of which the Munjal family is the biggest beneficiary. In 2009, the company said it was sitting on a cash reserve of over Rs 40 bn and it was looking at a number of ways to use these funds, including special dividends and expansion of capacity. Over the next two years, shareholders were suitably rewarded with bumper payouts.

    ACC saw an increase in dividends paid out in 2011 on occasion of the company's Platinum Jubilee.

    While the dividends paid out were overall impressive, the returns generated over the past 5 years are not equally impressive. Investors should take note that all dividend paying companies are not created equal. As seen in the table below, cyclical stocks including commercial vehicle maker Ashok Leyland and cement producer ACC have seen modest returns in their stock prices over the past 5 years. HPCL's returns are also heavily dependent on crude oil prices.

    Company Name Returns over 5 years
    Hero Motocorp 196%
    HPCL -2%
    Ashok Leyland 1%
    REC* 53%
    ACC 9%
    * Since March 2008 IPO
    Source: Ace Equity

    Hero Motocorp and REC on the other hand have seen impressive returns. Hero Motocorp has benefitted from India's growing consumption class and demand for its two wheelers. REC has benefitted from the growing demand for power in the country, the generation and transmission of which needs to be financed.

    Other companies which have also seen an impressive increase in dividends over the past 5 years include Infosys, Federal Bank, IDBI Bank, National Hydel Power Corporation (NHPC) and ITC.

    To conclude:

    Now, even if the returns on some of these stocks may not be very impressive from a 5 year basis, you could have still recovered some of your money through dividends. Thus these stocks provide an insurance protection to your portfolio against stock market volatility. But all such stocks are not created equal. On a conservative basis investors could avoid investing in cyclical companies. They may be unable to maintain constant profitability. This in turn endangers their ability to pay dividends consistently. Instead, investors should focus on businesses whose products will be in demand regardless of the economic environment. This will ensure that they maintain a steady payout. Consumption driven companies, utilities and companies which provide an underserved need are thus your best bets.

     

     

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