Curated Portfolio | XC Quant: Dividends
By Arhan Parikh (arhan.parikh@xumitcapital.com)
Why Dividends
When you buy a stock, your potential return comes from two sources. The first and the most obvious one is the expected price appreciation in the stock itself and the second, less considered one, is the dividend that you expect the stock to pay over time. Dividends are not a separate source of income to the shareholders but rather they represent the portion of income (earnings per share [EPS]) that is actually paid out to the shareholders. In one way or the other, dividend-paying stocks can be compared to bonds since they generate income but they have an added benefit that bonds do not provide: potential for price appreciation. If a stock has a dividend yield higher than the coupon on a bond and since it already has an added benefit in price appreciation, is it not a win-win situation for one to simply invest in dividend-paying stocks than invest in non-dividend paying stocks or bonds? The answer to this question is not a simple yes or no. There are a lot of other factors that play a key role in whether dividend-paying stocks make better investments than non-dividend-paying stocks.
Issues with relying solely on dividends
Investors who tend to be income conscious favor stocks with high dividend yields. Simply trying to choose stocks based on their dividend yield is not a foolproof strategy. The reason is simply that a high dividend yield neither indicates the sustainability of the dividend payment nor anything about the expected growth of the company. A high dividend yield and a high dividend payout ratio could simply mean lower future anticipated growth, unsustainable dividend payments, and no price appreciation in the stock price. Additionally, dividend yields that are too high often indicate there is a problem with the company, and could indicate that the dividend is likely to be cut. Investors who wish to reap the benefits of a dividend investment strategy should consider a few other factors along with just the dividend yield in order to ensure that they get the best of price appreciation and dividend payments.
Factors along with dividends that investors should consider
An investor can consider factors such as valuation, cash flows, and growth, along with dividends. Implementing a multi-factor approach to investing ensures that the investment strategy is robust and better to withstand market volatility. Employing a strategy consisting of valuation, growth, and cash flows tell an investor that a company is capable of expanding its business, that its assets are productive, has growth potential, has strong cash-generating abilities, and is available at attractive valuations, ensuring that an investor does not overpay for those assets or profits. Such a strategy would comprise companies whose earnings growth are increasing and consistent, whose cash flows are both positive and attractively priced and are paying significant dividends. Such a strategy wouldn’t simply include companies with the highest dividend yields but rather include companies that pay dividends that are sustainable, have expected growth, are profitable, and generate cash. Combining these factors ensures that growth, value, and cash flow factors are being combined with both accrual and cash-based accounting in a single strategy.
Valuation strategies in general work well quantitatively and have provided strong and consistent excess returns. It ensures that an investor is never overpaying for an asset, no matter whether it is equities, fixed income, gold, real estate, or any other asset class. Purchasing something at or below fair value ensures that the investor is likely to earn above-average returns as the market eventually values it at its fair price. Apart from valuation, cash flow is one of the most predictive factors when analyzing a company. The reason cash flow is important is that cash represents a reality whilst accounting earnings are not necessarily real. Companies that have strong cash flows will always ensure that in bad times, their businesses won’t suffer and that they will have enough resources at their disposal. As said, “cash is king”. Lastly, the final factor that is employed here is growth. Growth ensures that an investor avoids purchasing low-valuation stocks that are valued at such levels due to some inherent risk that is not evident to everyone. It ensures that an investor is investing in an asset that has growth potential and will reap the investor rewards.
In addition, one can consider looking at the performance of the Nifty Dividend Opportunities 50 Index and compare that with the benchmark, i.e. NSE 500. The Nifty Dividend Opportunities 50 Index is designed to provide exposure to high-yielding companies listed on NSE. The reason that it is important to consider NSE 500 and the Dividends Index is that if one simply looked at dividend yields and created a portfolio, he/she would have underperformed the benchmark, (i.e. NSE 500). The Nifty Dividend Opportunities 50 comprises 50 stocks within the NSE 300 universe that have the highest dividend yield. The Nifty Dividend Opportunities 50 is rebalanced on an annual basis, at the end of the financial year. Since the index’s inception in 2011, the total return (price return plus dividend return) has been 11.83% whilst the price return has been a mere 9.00%, underperforming the NSE 500, which has generated close to 14.00% price return. The chart below shows the outperformance of the NSE 500 index compared to the Nifty Dividend Opportunities 50.
A strategy of combining dividends, cash flow, valuation, and growth has generated strong excess results in the Indian market from 2012 to 2022. We call this strategy ‘XC Quant: Dividends’. We backtested results based on a universe of over 500 stocks based on annual data and using this strategy, one would have generated a compound annual growth rate (CAGR) of 36.97% over 10 years, handsomely outperforming the universe (NSE 500 stocks), which returned a mere 13.18%. The strategy has provided an excess return over the benchmark of a staggering 19.79% over this time frame, indicating its strength and robustness in different market conditions and time frames. This shows us that combining factors such as valuation, cash flow, and growth along with dividends ensures that an investor is getting the best out of every factor rather than simply relying on dividend yields, a strategy that has underperformed the benchmark (Nifty 500).
Apart from generating excess returns, this strategy also ensures that the stocks that are included provide high dividend yields. The XC Quant: Dividends provides a dividend yield marginally higher than the Nifty Dividend Opportunities 50, so investors who are income conscious and want to focus primarily on dividend yields and secondarily on price appreciation can consider investing in this portfolio since both its price return and total return are significantly higher than the Nifty Dividend Opportunities 50 index. Investing in such a portfolio is a win-win situation for income-conscious investors as the dividends paid are from companies that have sustainable dividend yields, strong cash flows, growth potential, and are available at attractive valuations. As indicated earlier, this is not a strategy that relies on just a single factor, but one that ensures that multiple parameters are checked, ensuring strength, robustness, and generation of excess returns. The chart below shows the outperformance of the XC Quant: Dividends portfolio in comparison to the NSE 500 Index.
Moreover, the chart below shows us that the XC Quant: Dividends portfolio has comprehensively outperformed both the NSE 500 and the Nifty Dividend Opportunities 50 Index. The Quant Dividends portfolio underperformed in only three out of eleven years, outperforming both the NSE 500 and the Dividend Opportunities 50 Index comfortably in the other years, indicating the strategy’s strength and robustness.
In the chart below, we see that when the strategy of combining dividends, cash flow, valuation, and growth are divided into quintiles, we see that the performance of the portfolio gets progressively worse, indicating that the top quintile contains companies that pay sustainable dividends, whose earnings growth is increasing and consistent, and whose cash flows are both positive and attractively priced, and hence they are the ones that perform the best.
The table below shows the quintile-wise performance of the XC Quant: Dividends strategy compared to the benchmark (NSE 500) over the ten-year period. Key statistics such as the Sharpe ratio, alpha, excess return against the benchmark, the number of times the strategy has outperformed the benchmark, and the average return are highlighted.
Just like the chart above, we can see that the Sharpe ratio of the quintiles also gets progressively worse as you go down, indicating that the top quintile contains companies that generate higher returns while taking on low risk. The benchmark (NSE 500) outperforms the fifth quintile but underperforms all the other ones, indicating that the strategy is indeed robust.
All in all, in conclusion, combining factors such as valuation, cash flow, and growth along with dividends is a much more robust strategy for an investor who wishes to invest in dividend-paying stocks rather than simply relying on high dividend yields. As indicated above, these factors when combined together work well and tell an investor that a company is capable of expanding its business, that its assets are productive, has growth potential, has strong cash-generating abilities, and is available at attractive valuations, ensuring that an investor does not overpay for those assets or profits. Such a strategy would ensure that an investor is simply not investing in a portfolio with the highest dividend yields but investing in a portfolio that comprises companies that pay sustainable dividends, whose earnings growth is increasing and consistent, and whose cash flows are both positive and attractively priced.
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References
Damodaran, A. (2006). High Dividend Stocks: Bonds with Price Appreciation? In Investment fables: Exposing the myths of “Can’t miss” investment strategies (pp. 17–56). essay, Pearson Education.
Tortoriello, R. (2009). Growth. In Quantitative strategies for achieving alpha (pp. 181–211). essay, McGraw Hill.
Tortoriello, R. (2009). Valuation. In Quantitative strategies for achieving alpha (pp. 103–149). essay, McGraw Hill.
Tortoriello, R. (2009). Cash Flow. In Quantitative strategies for achieving alpha (pp. 151–179). essay, McGraw Hill.
