Are High-Yielding Dividend Stocks The Right Choice?

Many of the high dividend-yielding blue chip companies tend to be consistent performers and are dependable when the stock markets are going through a bearish phase or uncertainty. Join Anthony Fernandes as he finds out how one can select quality dividend-yielding stocks to ride through difficult phases in the market.

The Indian equity market is in the midst of a perfect storm along with most of the world markets, across asset classes. The corona virus pandemic has led to economies coming to a screeching halt. The Sensex has lost more than 30 per cent so far this year; that’s nearly 13,000 points and is down about 33 per cent from its record high of 42,273 registered on January 20, 2020. In such a volatile phase, investors find themselves experiencing extreme emotional shifts with the unpredictable rise and fall that come with stock market investing, unsure whether they should put in their hard-earned money in the stocks now or wait for a better opportunity later.

During such times one must remember that the index has experienced severe declines and bear markets before. It has always recovered from them, and there is a high chance it will do likewise following its current woes. At such a time, companies with a high dividend yield can be an investment option to be counted upon. Many of the high dividend-yielding blue chip companies tend to be consistent performers and are dependable when the stock markets are going through a bearish phase or uncertainty.

An investor may not realise the benefit of less volatility when the market is stable, but when the market is going through a downtrend, these stocks may very well be the right bets to ride through the troubled times. Moreover, during market corrections like the one we are experiencing currently, there exists a huge opportunity to get quality dividend stocks at 20 or 30 per cent discounts. All investors need to do is to spot where these low hanging fruits are.

In the below table we have selected stocks from the BSE 100 that have shown a sizeable increase in EPS and DPS growth on a YoY basis for 5 years. These stocks have high promoter holding and have a debt to market ratio of less than 1, indicating that these are low leveraged companies. We can see that the median 5-year CAGR as of March 16, 2020, is 15.52 per cent which is higher than the BSE 100 5-year CAGR of 1.22 per cent during the same period.

Investing in High-Yielding Dividend Stocks The question that comes to the fore is: why invest in high yielding dividend stocks during troubled times? Here are the reasons:

 Focus on the Yield Strong dividend-yielding stocks tend to hold up better than their nondividend- paying counterparts during major crashes in the stock markets. One reason this can be attributed to is the ‘yield support’ of dividendpaying stocks. To better understand this we can go through a hypothetical example. Dividend yields tell an investor how much he will be paid as a percentage of the stock price. So let’s say if Company A has stock priced at Rs. 100 per share, a dividend yield of 3 per cent on this stock would mean that it pays a dividend of Rs. 3.

Now assume a broad economic slump takes hold and major stock indices slump, including Company A, which is not spared. The stock which used to cost Rs. 100 has now crashed to Rs. 50. It has lost half its value but as it fell, the yield has now doubled to 6 per cent. It now just costs Rs. 50 to get an annual dividend payment of Rs. 3 per share. Thus any investor looking for opportunities can be drawn to this guaranteed yield of 6 per cent per stock. Investors that step in can take advantage of this yield to reduce the impact of the downward momentum and sometimes can even reverse it. This is called yield support.

Of course, one must understand that yield support can break if the dividend payout ratio is unsustainable and hence one must only pick dividend stocks which have a reasonable dividend payout ratio. An investor should check if the company has a history of cutting dividends in the past and prefer those companies which show a history of rising dividends and not lowering them as companies that have lowered dividends in the past are likely to do so again in the future.

"The very attention we place on rising dividends puts us squarely in the position of 'owners' of a company, of true investors who understand that a satisfying and reasonable return from a stock investment isn't a gift of the market or luck or the consequence of listening to some market maven, but it is the logical and inevitable result of investing in a company that is actually doing well enough, in the real world, to both pay dividends and to increase them on a regular basis

Lowell Miller Author of The Single Best Investment 

 Dividends Demand Fiscal Discipline A key factor that is often overlooked when taking into consideration investing in dividend stocks is the fiscal discipline it indirectly brings upon the management. A company needs to keep cash on hand when a dividend payment date is approaching. If an investment opportunity like a potential acquisition arises, the management has to go to the drawing board and determine whether the investment is really going to generate the cash required to meet the dividend obligation. If the investment is too risky and there isn’t enough cash to cover all the company’s obligations, the management will likely pass on the offer. On the other hand, if the company does not worry to cover dividend disbursements, then it is more likely to be willing to undertake riskier investments and even operate at a loss, hoping that its investments will eventually generate profit.

 Accelerate Returns through Dividend Reinvestments Reinvesting the earned dividends can further increase the yield. Investors can invest systematically to accumulate dividend stocks. Then the earned dividends from such stocks if reinvested, especially if the stock is at a relatively low point, can serve the dual purpose of slowing downward momentum and acquiring relatively cheap shares. In this regard, investors can either reinvest their dividends as they come in or sign up for a dividend reinvestment plan. Increasing the number of stocks means an increase in the regular flow of income or more dividend income which can again help you to acquire more shares. It is said that ace investor Warren Buffet earns a billion dollars solely in dividends.

Investment Risks in High Dividend Yield Stocks

Whenever you sign on the dotted line with a broker, a mutual fund manager or any financial intermediary, one is often presented with a long disclaimer than basically boils down to a single statement: ‘Past results are no guarantee of future performance.’ In other words, yesterdays winners can very well be tomorrow’s losers. Investing always carries some risks and dividend stocks are no exception. Shares can drop whether a company pays dividend or not and companies can eliminate their dividend payments at any time for any reason.

Not all high dividend-yielding stocks offer sound investing choices. Specifically, companies under extreme stress which have a long-term history of paying a regular dividend can simply raise dividends because it’s the only way to attract buying interest. There isn’t much point in owning a share that pays a 6 per cent dividend if it’s falling by 15 to 20 per cent per year on average. Hence, an investor must perform the necessary due diligence for any stock and examine the company fundamentals to determine whether it is a good fit for his portfolio.

"Dividends may not be the only path for an individual investor's success, but if there's a better one, I have yet to find it

Josh Peters Author of The Ultimate Dividend Playbook 

Financial Ratios Associated with Dividend Paying Stocks Dividend investing is part art, part science and financial ratios make up for most of the science behind investing. While there are hundreds of different financial ratios that can be used, understanding a handful of the most important indicators can go a long way in helping investors sidestep avoidable mistakes.

 Dividend Payout Ratio: Perhaps one of the most common financial ratio known to dividend investors is the simple dividend payout ratio, which measures how much of the companies investors are paid out in dividends. It is calculated by dividing the amount of dividends paid by the amount of earnings generated. For example, if a company has Rs. 100 in earnings, a payout ratio of 60 per cent would mean that the company is paying Rs. 60 in the form of dividends.

Investors need to analyse the dividend payout ratio because it is a clear indicator of how safe a dividend is and how much room it has for further growth. A higher dividend payout ratio (above 80 per cent) could mean that the dividend payout is risky as it consumes most of the company’s earnings. If business trends unexpectantly change, companies with high dividend payout ratios will find it difficult to pay out dividends. Hence, unless the business is highly stable and maintains strong financial health, investors should avoid investing in companies with excessive dividend payout ratios.

 Dividend Yield: Dividend yield is the measure in the form of a percentage of how much an investor has earned from the dividend he has received. The yield is the percentage of a stock's market price a company returns in the form of a dividend. For example, if a company pays an annual dividend of Rs. 50 and the current market price of the company's stock is quoting around Rs. 1,000, then it has a dividend yield of 5 per cent.

The dividend yield is a good ratio to measure for dividend as compared to others because it takes current market price into account to calculate the returns.

 Free cash flow: Without consistent free cash flow a company is unlikely to survive over the long run and hence these firms are unlikely to have any funds to return to shareholders through dividends or stock repurchase. In almost all scenarios it is preferred to invest in company’s that generate consistent free cash flow. Free cash flow is calculated using the company’s cash flow statement. There companies capital expenditure (money spent on property, plant and equipment) is subtracted from its cash flow from operations (CFO), and this value is further adjusted for non-cash charges such as depreciation to arrive at free cash flow.

 Net Debt to Capital: Excessive financial leverage can be dangerous for businesses and this is the main reason we look at the net debt to capital ratio. The metric tells us how much debt a company is using to run its business. For example, if a company has the equipment it purchased at Rs. 100 supported by Rs. 20 or debt and Rs. 80 of equity.

Then, the debt to capital ratio will be calculated as the total book debt (Rs. 20) divided by the total book debt (Rs. 20) plus equity (Rs. 80). The result is the net debt to capital ratio of 20 per cent. It is preferred to invest in companies with a net debt ratio of less than 50 per cent, although there are some businesses which can reasonably take on more leverage.

If a company unexpectantly falls on hard times and it has too much debt and interest to repay with its dwindling cash flow. Its stock price can get crushed and dividend payment can come to a standstill.

 Total Shareholder Return: As dividend investors, there is a common temptation to focus on one yield alone; the dividend yield, since it is a very tangible form of return. While it is important, one should understand the importance of the total return as well. What good is a dividend yield of 6 per cent is a stock falls by 50 per cent in value after all? Total shareholder return measures the increase in the stock price, including all dividends paid. For example, shares of Company A were trading at Rs. 50 at the beginning of the year. If its shares are trading at Rs. 58 at the end of the year and the company paid a dividend of Rs. 2 during the year, then the stocks total shareholder return would be 20 per cent. A well-managed business should create shareholder value atleast in line with the broader market.

Selection Parameters for Quality Dividend Stocks The basic principles of identifying good stocks can be applied when identifying a good dividend-paying stock as well. While identifying dividend-paying stocks, one needs to look for those that have already grown substantially in the past and are in a stable stage in their business with decent growth on a year-on-year basis. This is because companies in the growth stage of their business cycle do not pay regular or high dividends as these companies are more concerned with reinvesting their surpluses back into their businesses for expansion. On the other hand, companies in a mature stage in their business lifecycle have less need for expansion and have surplus cash flows which they can distribute to shareholders.

An investor should ideally pick high market-cap stocks with a dividend yield of more than 2 per cent and a payout ratio of less than 80 per cent – the reason being it is not sustainable in the long run to pay a substantial portion of the earnings in dividends. Companies with a promoter holding of more than 50 per cent are to be preferred whereas a debt of market-cap of more than 1 should be avoided. Investors should select companies which have higher EPS growth than DPS growth as they have a higher probability of outperforming benchmark indices. These are some of the parameters one should take into consideration while picking these dividend stocks. 

In uncertain times, dividendpaying stocks with high dividend payout ratios can rapidly decrease in value because there is a risk that future dividends will be reduced. If a company announces that it's lowering its dividend, the stock price will react immediately. If the economy gets worse, the stock price might fall even further in anticipation that the company will completely stop paying the dividend. 

Conclusion While it is advisable to look positively at high dividend-paying stocks, the process of identifying dividend-paying stocks cannot be understated at all, as it will ultimately be the difference between picking a quality stock or not. Investors are recommended to focus on those dividend-paying stocks which have shown earnings growth in the past along with growth in dividends, albeit less than EPS growth. This will highly increase the chances of picking a stock that can outperform the benchmark returns.

The recent abolition of the Dividend Distribution Tax (DDT) in the Union Budget of 2020 and the lowering of corporate taxes will greatly reduce the cost of doing business for dividendpaying companies such as TCS, HUL and ONGC. By removing DDT, the quantum of profit available for distribution would be significantly enhanced. Corporates now will either pay more dividend to investors or use the excess funds to diversify their business, thus providing more impetus to the dividend investing strategy.