DSIJ Mindshare

Dividends Can Make You Rich

Dividends often meet with step motherly treatment vis-à-vis capital appreciation. Investors tend to focus too much on the capital appreciation part of investing in stocks, considering dividends to be only a miniscule aside being added to the overall value that is created. Is this true? Do dividends paid out by companies to shareholders from the profits they earn make no dent at all when it comes to value creation? Well, read on. We are sure this story would permanently change your perception about dividends and value investing in good stocks. The insights provided by the study that we have conducted on dividends paid out by companies over a period of 16 years suggest that investors need to be as serious about dividends as they are about capital appreciation. As these findings suggest, dividends can make you really rich.

Good and consistent dividend paying companies have always been looked upon as sound investment bets by investors across the world. Voluminous research has been conducted and documented on various topics relating to dividends and dividend paying companies. Despite all the research, whether consistent dividend paying companies are better investment options in terms of capital appreciation than non-dividend paying companies across market conditions (whether a bull or a bear market) is a fairly debatable point.

Whatever the answer is, the fact remains that dividends form an integral part of your investment returns and have the ability to enhance your total returns beyond your imagination. Take the example of Hero MotoCorp. For an investment in this stock at the start of year 2000 (when the stock market was at its peak), the total return at the end of 2011 would have been at more than eight times. Now add to this the dividend earned by the investment over these years, and the total returns shoot up to almost 10 times. What this means is that almost onesixth of the total return is generated by dividend income. Note that this does not include the reinvestment of dividends.

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How Important Are Dividends?

The importance of dividends over the long term can be gauged by a comprehensive study conducted in the US and the UK stock markets from 1900 to 2000 by Elroy Dimson, Paul Marsh and Mike Staunton. They found that a market-oriented portfolio that included reinvested dividends would have generated nearly 85 times the wealth generated by the same portfolio relying solely on capital gains. This wealth accumulation would, of course, have been lower if the dividends were not assumed to have been reinvested.

Indian investors would also have benefited in a similar manner, had they taken dividends seriously. To take the same example of Hero MotoCorp, if we consider a study period of 16 years from 1996 to 2011, the contribution of dividend has been at 16 per cent of the total return. This falls to 13 per cent if we bring our study period down to eight years. The difference in returns is without taking the reinvestment option into account. Had we considered the dividend reinvestment option, the difference would have been much wider.

While this may not be the case for all dividend paying companies, the example adequately proves the importance of dividends for any investment opportunity. What is important to note is that as we extend the study period, the share of dividend income increases in weight and plays a more vital role in the total returns.

If you stay invested in a counter over a fairly long period of time, corporate actions such as splits and bonuses further enhance the value of dividends that you receive over a period of time. For example, if one would have purchased 100 shares of Infosys at the start of year 2000, these would have become 1600 shares currently. Therefore, the benefit of dividend income gets multiplied by same amount in case you receive bonus shares issued by the company.[PAGE BREAK]

Some may argue that such returns are generated by taking a higher risk. In fact, quite contrary to this, it has been observed that good dividend yielding stocks fluctuate less. The reason for lower volatility is that these stocks with high and apparently sustainable dividend yields may be more resistant to a decline in price than the lower-yielding securities, because the stock is, in effect, ‘yield supported’. What this means is that once the price of a higher yielding stock falls, the dividend yield rises again. This makes the stock attractive, which in turn, helps in pulling up the stock’s price.

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Public Vs Private

So, is it only well-performing private sector companies that have created wealth for shareholders by paying them substantial dividends consistently? We checked with ONGC, a public sector entity, and analysed the role that dividend has played in the overall investment returns that the stock has provided.

Considering data from the year 2000 and adjusting it for splits and bonuses, we added up the dividend paid by the company over the period of the study and found that the scrip has generated a total CAGR of 22 per cent till now. However, if we remove the return generated by dividend, the returns drop to 19 per cent, which means that a good 14 per cent of the entire return is generated by the dividend earned. These returns are calculated without considering reinvestment of the dividend income. For this, we calculated the internal rate of return (IRR) (which takes the time value of money into account) generated by the dividend paid by ONGC over the same period, and that alone comes to around 11 per cent. This has easily beaten inflation over the same period.

Tax Efficiency

It is clear that a seemingly small amount of dividend received over a longer period plays a dominant role in generating healthy overall investment returns. The icing on the cake is the post-tax scenario. Dividend income is tax free and this dividend amount can be reinvested further without any tax implications, thereby providing good tax free returns to stakeholders. Moreover, even exiting the investment by selling out the shares is tantamount to generating long-term capital gains, which are also tax free.

This effectively means that the overall position of the whole investment from the taxman’s point of view is completely in favour of the investor.

Sectoral Trends

Is there a trend in terms of sectors or business groups that have consistently paid dividends despite the economic cycle they operate in? To answer this, we considered all the companies that have consistently distributed dividends to shareholders since FY01. Of the total listed space, there were 500 companies which have passed this test, consistently declaring dividends since FY01.[PAGE BREAK]

One surprise here is that the list is topped by Auto and Auto Ancillary companies. There are 39 such companies in all. One of the reasons for such a high concentration of these sectors may be the presence of more listed companies from them as compared to other sectors. Another reason could be that companies from these sectors have been listed for quite a long time now. The next best sector is Pharmaceuticals, which is represented by 33 companies.

In addition to these, other sectors that have shown a consistent dividend paying ability are Textiles, Finance and Software companies.

Taking this one step further, we tried to identify the sectors that have not only been consistent in dividend payment, but have either increased or at least maintained the level of dividend that they have paid over the years. This changed the pecking order slightly.

Auto and Auto Ancillary companies did not find a prime place in the list of top five sectors. There are only four companies from these sectors. The reason for such a low representation in this case is the vulnerability of these sectors to interest rate variations and other economic cycles, which increases the risk to their profitability and hence, their dividend payment ability.

Public Sector Banks (PSBs) have topped the chart, with seven banks in the list out of a total of 77 companies. The reason for this may be the comparatively better performance of PSBs during the last financial crisis. The next best sector is the Pharmaceuticals sector, which is represented by six companies. This tells us that pharmaceutical companies are far more reliable when it comes to predicting dividend distribution. The reason for such consistency in dividend payment is their stable financial performance, helped by their ability to navigate through troubled times much better than many other sectors. Other major sectors that have featured in the top five list are Software, Housing Finance and Personal Care.[PAGE BREAK]

Now let’s take a look at the sectors that that have doled out the highest dividends in absolute terms for FY11. The total dividend distributed by 1546 companies in FY11 stood at Rs 97545 crore. The industry that distributed the highest dividend is Oil Drilling & Exploration, with the total distributed amount standing at Rs 16224 crore. This was followed by Software, where companies paid out an aggregate of Rs 8582 crore as dividends in FY11. However, if we take the average amount distributed, Oil Drilling & Exploration again topped the chart with an average of Rs 1622.4 crore, followed by Cigarettes, which distributed Rs 1183 crore per company on an average.

These dividends have not only made retail investors rich, but have also made the promoters of these companies richer (See list), the highest among them obviously being the Government of India, represented by public sector units.

So, does this means that one should look at only these sectors to find companies that will create wealth from dividend income? Well, we do not feel so, as in our study we have found that the leading companies of the major sectors are mostly consistent in dividend payments despite ups and downs in their business cycles. For example, Tata Steel, a major global steel player, has been a consistent dividend paying company, and has either increased or maintained its dividend level since 2002. It reduced its dividend percentage only in FY10, but again increased it in FY11. Compare this with another major steel player, Steel Authority of India (SAIL), which skipped dividend payment for almost six years continuously from FY99 to FY01. What this essentially means is that if you stick to good companies from a not-so-good sector, which are prone to the vagaries of business cycles, you still will be rewarded by dividends.[PAGE BREAK]

How To Select The Right Companies?

Where is all this discussion leading us to? How should one select the right companies that will help investors with a long term investment horizon? Here are some broad contours on selecting the right dividend paying stocks that will help you to create wealth over the years.

Basically, there are two key considerations that you have to take into account while selecting good dividend paying companies. The first is the sustainability of the dividend paying capacity of the company. The second is to see that the company is not paying out too much, which could hamper its long-term growth prospects. In fact, the second reason is slightly more important, as companies need to reinvest a part of their earnings to be able to grow in the future.

To check the sustainability of the dividend paying capacity of a company, you should compare the dividends to earnings. In simple words, the dividend payout ratio in the most recent period needs to be looked at to see whether the company is paying out too much. You should definitely avoid companies that are paying exceptionally high dividends, except for some cases where this is an exceptional instance.For example, Kanoria Chemicals & Industries paid a 100 per cent dividend in FY11 as compared to the 30 per cent dividend that it had been paying for the previous six years. Its payout ratio was also 192.4 per cent of the net profit, which is certainly alarming, as it looks unsustainable. However, the reason for such a high payout ratio was the distribution of the profit of Rs 357.97 crore generated by the company after the sale of its Chloro Chemicals division. The chances of such companies maintaining the dividend at the same level are more, as they are not digging from their reserves. Hence, they can be considered.

The next question that may arise is what the normal payout ratio should be. This depends upon on what phase of growth the company is in. The payout ratio is low for a growing company, whereas it tends to be higher for a mature company. For example, Colgate-Palmolive (India), which is a mature company, has distributed 80 per cent of its cash earnings in the last five years as dividend to its shareholders. Similar is the case with various other FMCG and cigarette companies. However, some other companies, especially in the Steel sector that require higher investments, have a very low payout ratio. For example, Bhushan Steel had an average payout ratio of just 1.68 per cent in the last five years and Jindal Steel & Power had a payout ratio of 5.2 per cent in the same period.[PAGE BREAK]

For the 500 consistent dividend paying companies that we have analysed, we found that the median of the last five years’ dividend payout of the net profit is 28.3 per cent as compared to 18.8 per cent of the cash profit. Therefore, we believe that if an average company is paying around 30-35 per cent of its net profit and around 20-25 per cent of its cash profit as dividend, chances are high that it will sustain its dividend payment even it sees a couple of bad years.

So far, we have discussed what we need to look at from the past performance of companies. However, wealth creation depends upon the future growth prospects of companies. To calculate the future growth, we need to see the type of returns generated by a company’s investments, which is correctly reflected in its return on net worth. Future growth in a company’s earnings is a product of the return on net worth and the retention ratio. This is the amount left after distributing dividends. In our study we found that list of companies providing the best return on net worth is dominated by the multinational corporations and FMCG companies. Therefore, the likelihood is high that companies with a lower dividend payout ratio or higher retention ratio coupled with higher return on equity would continue with their dividend payment policy.

Conclusion

Dividends form a major part of the overall stock market returns over a longer period of time. There are various empirical studies that suggest that stocks with high dividend yields have enjoyed interesting return advantages over their lower dividend yielding counterparts. However, one should keep in mind that all these studies have indicated that dividends play an important role only in the long run and not in shorter periods, say three to five years. Therefore, it is important for investors to pay attention to the dividend payments and their own investment horizon before committing their funds.

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