Suitable for investors with low risk appetite. They may not appreciate as much as growth stocks but they hold up well in a downturn
20-Aug-2010 •Research Desk
If you are a defensive investor, you should have high dividend yield stocks in your portfolio. Even if you are not of the defensive kind, then also you should have some exposure to these stocks as they will help shore up your portfolio during rough times.
High dividend yield stocks have many advantages. They tend to fall less than growth stocks during a downturn in the market. Moreover, companies shy away from cutting dividends even in tough economic conditions, since this sends a negative signal to the market.
But high dividend yield stocks also have a few disadvantages that you should be aware of. For instance, when you chose to be a defensive and not an aggressive investor, you knew that you were sacrificing returns in favour of low risk. Similarly dividend yield stocks too have their limitations. No high growth company pays high dividend, since the management would rather plough the surplus cash back into the business. High dividend yield stocks also tend to appreciate less than growth stocks. Generally mature companies tend to offer high dividend yields. These are companies which are past their stage of explosive growth. Predictable growth also translates into predictable stock prices.
This time around we have made our screening criteria tougher. We have introduced new variables like return on net worth and interest coverage ratio. Let us look at our screening criteria in detail:
Dividend yield. It is the percentage of the dividend paid per share divided by the stock's current market price (in this case, as on July 22, 2010). We considered only those companies that have a dividend yield of more than 4 per cent.
Dividend payout ratio. It is a measure of the proportion of profits paid out as dividend. Here we have used dividend payout ratio to weed out those companies that are inconsistent in paying dividend. Only companies which have been consistently paying dividend during the last five years have been considered. The set of companies that we got has an average dividend payout ratio of 0.44.
Earnings per share. We selected only those companies that have shown a growth in earnings per share (EPS) of more than 20 per cent every year for the past three years.
Return on net worth. This is expressed as a percentage of the net profit of the company divided by its net worth. The net worth is the total liability of the company to its shareholders. We selected only those companies that had an average return on net worth of 20 per cent over the past three years.
Debt-equity. A high debt means a high investment risk. This is one risk that investors should avoid. Debt to equity ratio is the ratio of debt raised by the company from the market compared to its own capital. Normally companies with debt-equity ratio lower than two are considered to be safe. This is the criterion we chose to go by.
Interest coverage ratio. This ratio is defined as operating profit of the company to its interest expense. It is a measure of how much the company is earning compared to the cost of servicing its debt. Higher this ratio, lower the chances of default. We chose companies that had an interest coverage ratio of at least two.
What we got
This month our list saw a major overhaul, owing largely to the tougher criteria that we introduced in order to ensure that only companies that were sound fundamentally would come through. Two companies -Wyeth and SRF - which were among the top three dividend yielding companies last month, dropped out of this month's list. Altogether seven companies got eliminated: three failed to meet our more rigorous tests for fundamental soundness, while four dropped out because their dividend yields declined. Three companies got added to our list, taking the total tally to five.