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Dividends play a real role

In bad times, high dividends are a great help for equity investors

Dividends play a real role

It's strange how so many equity investors are blind to the impact that dividends can have on equity returns. Over the last few years, the dividend yield of a lot of stocks has risen but this fact has bypassed the thought process of most investors. Why are Indian investors largely oblivious to dividends? Perhaps because there are relatively few long-term buy-and-hold investors. If equity investors are generally looking at quick gains and exits then it does not really matter if a stock has an impressive dividend payout.

I remember a curious incident in September last year when I came across a tweet from a financial advisor which lamented the fact that after exactly five years, a particular big name stock was at exactly the same level. It had had its ups and downs in the intervening half-decade, but had ended up back at the same stock price, indicating no gains at all. It was a coincidence, and didn't look like a happy one. The tweet had collected a good number of likes and retweets and copies and the idea was generally going around a bit. However, to me the whole thing seemed a bit odd because although I hadn't looked at this company closely, my impression was that it was a reasonable dividend payer.

So I entered the purchase into the 'My Investments' feature on Value Research Online and checked the returns. The investments tracking system on the website automatically looks up and applies all bonuses and dividends automatically and calculates the effective returns. It turned out that this five-year investment, which looked like a dud if one looked at the quotes because the stock price was at exactly the same level, would actually have resulted in a 12 percent total gain over the period. Even now, despite all the carnage from the Chinese virus, the stock has a marginal loss of 5 per cent. Obviously, this is not what you want from equity and this is an exceptionally bad time, but the point is that the dividend payout substantially changes the picture. If you do not take dividends into account then you get a spurious picture of what you set to gain from an equity investment.

In fact, there's more to the story because in recent years, the dividend yield (annual dividend payout as a percentage of the stock price) has generally been improving. Once upon a time, top-of-the-rung companies used to have quite poor dividend yields, but no longer. In February 2015, the 30 Sensex companies had an average dividend yield of 1.15 percent. Now, this is 1.65 percent. This is a numerical average of the individual dividend yields and hides the fact that there are many companies for whom dividends have increased manifold. The trend holds below this level too.

Is there a reason for this? Broadly, it's probably because during this period companies have not invested their surpluses much. Fundamentally, that's not a happy reason but investors will take what they get. The important thing is that in times of sluggish stock price growth, dividends provide a cushion that makes a material difference to whether a stock is worth holding. There are many businesses where a distribution of profits makes more financial sense than further reinvestments. In fact, the stock whose story I have quoted above is ITC, which is exactly in such a business. The company has a stated dividend policy of distributing a certain proportion of profits, currently 80 per cent. The flipside are many public sector companies where the government extracts high dividends even if the business can't afford it but PSUs are always a different story.

Going by the theory of dividend-centric equity investing, a high dividend yield is a good criterion for selecting stocks. However, in the real world of Indian investing, that's not really true. Dividend yield is the result of a skewed ratio of dividend and stock price. Its root cause is almost always a stock price that's too low and the question to ask is why is it too low. However, if the dividend is a reasonable ratio to the fundamentals (not the price) of a company, and that dividend is paid consistently, then that's a strong positive signal about the financial health of the business.

It's not good enough to be the sole basis on which to choose stocks, but it's not a bad thing to have anyway.