Global Outlook

Indian Investors should opt for a good dividend-paying company.

Contributed by Nirmal Bang

By Nirmal Bang

What would you like  to have: a scenario where you work for money or where the money works for you? Obviously, we all would like the  money to work for us. And is such a scenario possible? Yes, it is possible if you are an equity investor and choose to invest in some of the good dividend-paying companies.

POWER OF DIVIDENDS

In investing, two most powerful tools have contributed to the wealth of legends like Warren Buffett. One is the power of compounding and the other is the power of dividends.  While most of us are aware of these two concepts, let it be known that dividend is an interesting topic and should not be ignored.

American business magnate and investor Warren Buffett is one  individual whose real income comes from dividends he receives from his personal holdings.

In fact, if we consider his take home salary, then he would not even feature among 30% of the world’s top earners. Buffett draws an annual salary of about $1,00,000. But this is nothing compared to $42,583,971 in income last year he generated from dividends alone. Simply put, his dividend income is 425 times greater than his salary.

Not many of us give proper attention to dividends. Yet, it can make a huge difference in the long run. Even if you assume a portfolio return of 15% over the next 30 years, an additional dividend income of say 3% can allow a person to retire easily in the 26th year instead of the 30th year in the earlier case.

The uniqueness of dividends is that it is not static like the interest on a bank deposit. If you choose the right company stock, then dividends could grow at a far higher rate than you could ever imagine.

In the current market scenario, it is most important to keep a close eye on dividend-paying companies or hunt for one. This is because dividends not only provide a defence in volatile market conditions, but also reward investors if share prices appreciate when the markets recover.

But more than timing the markets, dividend-paying companies tend to outperform over a period of time and become an important source of regular income, like in the case of Warren Buffett.

In fact, dividend is the actual income that a share holder is entitled to. The rest depends on market conditions.

SHORT-SIGHTED OR LONGSIGHTED

An extraordinary temptation for higher dividend yield stocks could be fatal. Simply choosing stocks that are trading at a high yield based on last year’s dividend may not be true  especially in the current economic environment where earnings could be far more volatile in the coming year or thereafter.

The fact is that individuals should dwell more and scrutinize whether a company is trading at a very high dividend yield. Even in the current markets, there are several companies that are trading at 15% to 20% dividend yield, which is far more than the dividend yield that is offered by the market as a whole.

One should ask for the reasons behind such inefficiencies in the markets. Does the market know more than we know? There could be several reasons to this.

One of them is that maybe the markets are expecting the company to report a fall in its profits next year or last year’s dividend on which the current yield is worked out includes income from extraordinary items or a special divided, which may not continue next year.

Investors should also be careful about cyclical company stocks because when things are good and the industry is booming they tend to give handsome dividends, but when the tide turns they tend to cut their dividends drastically.

One should not compromise on the quality of the investment in the hope of high dividends. The basic premise  of dividend-paying companies is that they are high quality companies with transparent managements.

QUANTIFYING THE DIVIDEND YIELDS?

There are two ways of looking at dividend yield stocks. Unfortunately, most of us focus on last year’s dividend or at the most the coming year’s dividend.

A stock may be trading at 3% dividend yield based on the last fiscal, but for an investor who takes a long-term view, it could be offering 10% to 15% yield.

If you bought Hero MotoCorp in the year 1991, when it was trading at Rs.7 per share, today the dividend yieldwould have worked over 5000%based on last year’s dividend  payment. It is possible, if the same stock which is currently offering 3% yield, keeps on increasing its dividends year after year.

THE KEY TO TREASURE

The key to the treasure lies in understanding where companies pay dividends from and why do they pay.

Typically, if a company makes profits from its business activities, the management has two options - either retain the same as profits in the books or distribute it in the form of dividends to its shareholders.

Companies may choose to do so depending upon their individual requirements for the funds to be  redeployed in the business. This is fair in a growth phase as companies invest the cash back into the business.

However, investors should ask if the money being redeployed is bringing  incremental growth to the business and the returns on the investments are not destroyed.

Individuals must pay attention to emerging companies; initially they do not offer much dividend but when they reach a scale over a period of time they are most rewarding.

Consider a company which is into the Internet space. Such companies do not need much capital after they reach a scale and whatever they earn is paid back to the shareholders.

Also, when companies reach the scale they incur less expenses and economies of scale work in favour of the company, resulting in very high return on equity (RoE).

Look for businesses that are scalable over a period of time and require less capital as they grow. A lot of companies do not know what to do with the available cash.

At times the management too is not keen on diversifying into unrelated businesses using the surplus cash. Here the quality of the management and the dividend policies they follow are equally important.

Compared to the global markets, India’s dividend payout ratio is very low. Most Indian companies and managements prefer hoarding cash instead of paying them back to the investors as dividends.

CASH GUZZLERS

Stay away from cash guzzlers. Typically, in a growth economy one would ask why should companies pay dividends if they can deploy them  back into the business and generate additional returns or return on equity, which are large enough compared to the bank rate or the FD rates. However, that is not entirely true.

There is a catch though. As an investor one should ask if the company needs to maintain a permanent capital expenditure.

If companies keep on investing in new capacities for growth without paying much attention to returns, there could be risk to cash.

Typically, companies which require  less cash for expansion or companies  which require very less capital expenditure for incremental growth in revenue are the ones which reward shareholders in the long run.
 
Companies from the FMCG, automobile and pharma sectors are perfect examples of firms that require  very less capital to grow and generate very high returns on investments, leading to huge internal cash generation, which in turn, is paid back to the shareholders.

Here it is also important that the company have some sort of standing or position in the industry, which would enable them to maintain growth and protect returns.

For instance, companies like Nestle India, Hindustan Unilever, Asian Paints and Hero MotoCorp are considered to be the most consistent dividend-paying companies.

They also have a fairly large market share in the industry. Their brand name, customer loyalty and strong distribution and sales network let them enjoy growth year after year.

There are many companies in the utilities space as well. But most of them are still in the growth phase. Once these leading utilities are done with their capex, they will earn significant amounts of cash from their existing asset base.

Companies in the resources space like iron ore, coal and oil & gas too could be promising candidates considering that over a period of time they generate huge cash without the much needed capex.

A good portfolio of dividend-paying stocks is not made overnight. Initially there will be these disappointments where the dividend yields could be meagre. But if you have chosen the right company, the rewards may take longer but are sure to come by.

Just to give an example, in the last 20 years, Asian Paints’ dividend has gone up 55 times whereas the market capitalization has moved up by 75 times. Companies like HUL, Nestle and Hero MotoCorp have exhibited the same results a number of times in the past too.