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Dividends Yield Profits

Stocks with high dividend yields could be good investments. If, however, you are not sure, then you would be better off riding the dividend yield curve with a fund manager in the driver's seat

As the mutual fund industry grows in India, fund companies introduce newer and different products. Some of these are pure marketing tools, while others are actually new options for investors.

In the past few years, the dividend yield fund has emerged as an investment avenue for conservative investors. Birla Sun Life Mutual Fund was the first fund house to launch the product. Principal Mutual Fund and Tata Mutual Fund came out with their dividend yield funds about a year later, while UTI Mutual Fund has recently launched a similar offering.

To understand how this fund works, we need to understand dividend.

There are two ways to earn returns from a share. The first one is dividend income, which a company distributes from profits. The second way is capital appreciation, which is reflected in the increase in the share price. Together, dividend and capital appreciation constitute total returns from a share. While investing in stock markets, most investors only think of capital gains while dividend income tends to be grossly ignored.

Dividend yield is actually a simple arithmetic calculation: the dividend paid by the company in the last one year divided by the market price of its share. For example, if you held a share each of Bajaj Auto and Hero Honda, you would have earned dividend income of Rs 25 and Rs 20 respectively during 2004. In absolute terms, obviously Bajaj Auto provided you with higher dividend, but Hero Honda had a higher dividend yield of 3.5 per cent as against 2.21 per cent of Bajaj Auto because Hero Honda was a cheaper stock.

Dividend Yield: Your Highway to Profits

There are some reasons why high dividend yielding stocks make investment sense.

There is a documented investment style on Wall Street called "Dogs of the Dow". In this strategy, an equal amount of money is invested in the top ten dividend paying stocks of the Dow Jones index every year. This strategy has outperformed leading indices like Dow Jones, NASDAQ and S&P 500. In India too, this strategy has worked when back-tested.

The top ten stocks of a leading index are large companies with generally a good track record of dividend payout. Thus, these companies are most likely to continue paying dividend in the future.

Upon comparing the variance in returns of the top five and bottom five stocks of the Sensex, ranked as per their dividend yields, one would find that the average variance of the top five is lower than that of the bottom five. This goes to show that they are less volatile.

One possible reason for the lower volatility of these stocks is perhaps a lesser degree of capital appreciation, but the chances of a downward correction in a falling market are also less. Some of these stocks are also the value stocks characterised by a consistent track record of good dividend payments over the years. What happens is that during bear phases, such stocks can provide a cushion in the form of a stable dividend income, and during bull phases, you can even cash out on the capital appreciation.

Another advantage of this strategy is that there is an automatic mechanism to book profits at higher levels in the market. Suppose you make a portfolio with the objective of investing in stocks having a dividend yield of at least twice that of the Sensex. Now in a bull market when prices of your stocks start to rise, dividend yields will come down, and these stocks might become unattractive as per the criteria set by you. Hence, you will sell them and look for stocks with a higher dividend yield. This provides an automatic mechanism of selling stocks when prices go up and buying them when they fall (which will push their dividend yields up, thus making them attractive again). Thus, in a rising market, where you are not sure when to sell, the dividend yield strategy can show you the exit door in a very objective manner. To illustrate, the share price of Great Eastern Shipping zoomed from Rs 81 in September 2003 to Rs 153 in December 2003. This was coupled with a fall in the dividend yield of the stock from 4.94 per cent to 2.6 per cent. Birla Dividend Yield Plus Fund reduced its exposure to the share from 9 per cent of total assets to 3.3 per cent in the same period. Thus, the dividend yield strategy enabled to book some profits at the right time.

It is also worth a mention that all dividend yield funds follow a similar strategy. They set a minimum dividend yield as the hurdle rate to shortlist the stocks from the universe, and then invest in the ones which they find to be fundamentally good.

Though Speedbreakers Do Exist

Like in all types of investing, there could be some hurdles. The biggest challenge in this strategy is to pick out the stocks from the high dividend yielding universe which are actually worth investing into. One of the reasons for the dividend yield of a stock to be high could be that its price is very low, and a closer look may reveal that it is actually a badly-run company, and its stock price being the correct reflection of its worth. How do we separate the lemons from the oranges?

Since you are banking on a consistent dividend record of the company, you should assess the sustainability of its income in future before investing. Find answers to questions like: Have the earnings grown in recent years? Is the industry witnessing some positive trends? Does the company hold any competitive advantage which it is expected to hold in the future as well?

If the answers to the above questions turn out to be negative, then you better think twice before investing. The sustainability of earnings of such companies will be important. If earnings drop, dividends will follow suit. Taking these cues, the markets will discount the price of its shares before the event happens.

On the other hand, good companies with a high dividend yield will provide you with a stable revenue stream in the form of dividend, and the markets may price its shares higher in future considering its strong earnings potential, thus providing you with capital appreciation.

Another concern is to find quality stocks with a high dividend yield in a sustained bull market. As stock prices rise, dividend yields will fall. And during a bull run like the one that the Indian stock markets have been witnessing, a share has to be either really bad or still 'undiscovered' to be priced lower. Obviously, it is not so easy. No wonder then that as on January 31, 2005, both the Principal Dividend Yield Fund and the Tata Dividend Yield Fund had 25.07 and 27.41 per cent of their funds lying in cash respectively.

We had talked about how this strategy provides an automatic mechanism to book profits. But during an ongoing bull run such a mechanism may press the alarm button too early, and you might pull out at a time when you should have actually been stepping on the gas.

Shares of Balrampur Chini have been witnessing a sustained bull run since January 2003 when the price used to be Rs 100. In two years, the stock hit about Rs 600. Understandably, the dividend yield of the stock has seen a significant decline, from 7.5 per cent to 1.7 per cent. By following the dividend yield strategy, one would have exited the stock by the last quarter of 2003 at a price of around Rs 200 (dividend yield by that time had already dropped to around 3 per cent), and missed out on the tremendous capital appreciation that the stock has witnessed since then. Thus, during a prolonged bull- run, the dividend yield strategy can show you the exit door too early to make any significant gains.

Before You Get Into Over Drive

The strategy to look at the dividend yield history of the stocks can certainly provide you with a good starting point to pick out some good stocks. But at the same time, it can also mislead you to a portfolio of junk stocks. This strategy also fails to identify those stocks which do not pay dividend at all, but plough back all the earnings to generate further returns.

Therefore, high dividend yielding stocks can certainly find some allocation in your portfolio, but they should not be at the heart of your investment strategy.

Everything said and done, if you think that dividend yield strategy is your path to the riches, then let us pave the way by telling you the stocks that figure among the holdings of all the three dividend yield funds. (See Common holdings of all the three funds)

If, however, you are not sure, then you would be better off riding the dividend yield curve with a fund manager in the driver's seat.

Common Holdings of Dividend Yield Funds
Company  Tata DYF  Principal DYF  Birla DY Plus
Andhra Bank 0.58 1.81 3.46
Ashok Leyland 1.84 2.41 0.98
Bongaigaon Ref. & Petro. 2.54 2.07 3.87
Colgate-Palmolive (I) 0.19 2.01 2.34
Great Eastern Shipping Co. 2.84 4.69 2.85
H C L Technologies 4.55 3.67 1.52
Hero Honda Motors 2.14 4.53 5.54
Hindustan Petroleum Corpn. 2.18 1.74 1.76
Indian Oil 3.1 4.82 2.92
Oil & Natural Gas Corpn. 3.58 3.33 3.06
Tata Chemicals 3.39 4.11 3.31
Data (% of their respective assets) as on March 31, 2005