7 rules for smart dividend investing

By Larissa Fernand |  20-11-19 | 
 
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About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

The one stock in my portfolio that has delivered admirably is 3M India.

Someone recently asked me why I would own a stock that does not give dividends and went on to draw an equivalence with Avenue Supermarkets. (And, may I add, simultaneously bragged about his investment in Page Industries, a stock that has been generous with dividends.)

I get the lure of dividends. And I really love money being credited into my account. But, as I explained to that individual, my investment in 3M India was done with the prime goal of capital appreciation, and a cash flow was not something that interested me.

However, post the corporate tax cut, a recent note by ICICI Securities, stated that “sectors where growth is slow and stable but cash-flow generation is high should step up the payout to at least three-fourths of their profit because new investments will be risky in a slowing demand environment.” It also noted that high-dividend strategies perform better in times of falling global and local yields.

So if you are on the hunt for high dividend yield stocks, here’s what you must keep in mind. Years ago, Morningstar.uk came out with a few guidelines which I have built upon.

Don’t forget to dig deeper.

The stock could have a high dividend yield because the stock price has corrected sharply. (To calculate dividend yield, divide the annual dividend by the current stock price. For example, if stock XYZ had a share price of Rs 50 and an annualized dividend of Rs 1, its yield would be 2%.)

Maybe the latest dividend was due to a windfall profit. If it is a cyclical stock, then its current position in the cycle must be considered.

It could be, in the case of a public sector stock, that the dividend was declared on the demand of the government, its largest shareholder. Two months ago, Economic Times reported that the government wants oil companies to pay hefty amounts in dividends in a bid to raise resources for public spending amid an economic slowdown and corporate tax cut. In 2017-18, HAL had paid the government a dividend of Rs 1,165 crore. Over the years, thousands of crores have been paid by HAL as dividend to the government.

Don't ignore fundamentals.

Gains from high dividend stocks are often based on poor fundamentals. Many years ago, a study by French bank Société Générale found that “abnormally high dividend yields are generally a sign of danger” and its report went on to point out that groups of companies with ultra-high returns were more likely to have lower real returns.

Don’t ignore valuations.

Generally, when investors build portfolios centered on dividends, they buy shares simply based on their dividend yield, paying little attention to the valuation. That's a mistake. One should always try to buy securities with a safety margin, that is, with a significant discount (at least 10-15%) with respect to the Fair Value Estimate, or FVE.

Don’t go overboard.

If you only chase high dividend yield stocks, you may find that the bulk of your portfolio is concentrated in a few sectors. Ensure that you have a well-diversified portfolio that can absorb the impact from a dividend cut here and there. Too much of concentration can impair your portfolio’s ability to generate income in the longer-term and reduce your capital base.  While adding lower-yielding shares from other sectors may lower your initial yield, it could serve to increase the sustainability of your income stream.

Don’t forget your investment. 

Investors who want to build a well-constructed dividend portfolio must be patient. But, turning a blind eye to events that can affect a company’s dividend policy could backfire. There could be a case where you have to reevaluate your long-term thesis on a stock. For example, if a company borrows too much money to make a large and misguided acquisition or if competition has been eating away at margins, it may be time to reconsider that particular share.

Don't ignore the balance sheet

Paying too much attention to profit ratios and not enough to the balance sheet such as leverage, interest coverage or net debt / EBITDA is a very common mistake that dividend investors make.

Remember last year how individuals flocked to REC and PFC for dividends, but the stocks found no takers after the market correction? There was concern that the loans given to private sector firms may turn into non-performing assets (NPA). You can read about it here.

Don't think that dividends are equal to interest

Thinking that dividends are equal to interest is a big mistake. Unlike the interests of a bond or fixed deposit, a company has no obligation to pay dividends. Unlike bonds, a company is not obliged to pay back the amount invested on a given date.

Never forget: Dividends can be cut and dividend yields which look too good to be true usually are.

Here’s why the dividend payout ratio is a much more relevant statistic than the dividend yield.

Do Note: Investment involves risk of loss. 

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Vinay T M
Nov 27 2019 09:08 PM
Insightful!

Saw this somewhere recently - "Great investors pick growth stocks in the initial phase, enjoy the capital appreciation until the earnings compound and then read the benefits from the dividends once the co is too mature to grow".

Very famous ex - WB with Cocacola
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