XC High Dividend Yield Strategy
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. In one way or the other, dividend paying stocks can be compared to bonds since they generate income and there is potential for price appreciation. In the case of a bond, it is the coupon payment that you receive along with the potential for price appreciation. Since dividend paying stocks offer price appreciation along with dividend payments, should such stocks be better investments than stocks that pay low or no dividends at all?
To analyze whether higher dividend yield stocks earn higher returns than lower dividend paying stocks, it is important to consider historical data. Dividend yield is computed by dividing the dividends per share by the current stock price. Based on historical data from 2011 to 2020 in Indian markets, we can look at the Chart 1 below. There are a few outliers in this data set but by observing the trendline, one can conclude (even though by a small margin) that higher dividend yield stocks have generated a slightly higher annual return that those with lower dividend yields.
If we accept the argument that stocks that have high dividend yields are good investments, we need to look at a variety of factors that play an important role. One striking fact is that a large number of companies do not pay dividends at all. Amongst those that do pay a dividend, there is a large variation in yields. This is interpreted in the Chart 2 below.
Moving on, an essential point to note here is that there are differences in dividend policy across sectors. What constitutes a high or low dividend yield may depend upon the sector. Picking stocks that have the highest dividend yields in the market will result in a portfolio that is overweight in financial services, utility and PSUs since these are sectors that tend to pay the highest dividends. There are differences in dividends paid due to differences in fundamentals. Sectors with higher growth potential and more volatile earnings tend to pay less in dividends relative to their market value whilst sectors with more stable income and less growth potential tend to pay more dividends.
The best way to understand what a portfolio driven by high dividend yields would look like is to construct one and then analyze it. Looking at the data from over 700 Indian companies, the average dividend yield of companies over the last five years was computed with a cutoff of having a 7% or higher dividend yield required in order to be in the list. The Table 1 below shows the sectors that these twelve companies represent. We see that most of the companies are either in the financial services or power generation & distribution sector. There are companies from a few other sectors represented as well but we do not see any companies belonging to the Information Technology or Pharmaceutical sectors here since they tend to reinvest most of their earnings in order for higher expected future growth.
If you as an investor are looking into adopting a high dividend strategy, there are a few considerations to take into account. First, some high-paying dividend stocks may be paying much more in dividends than they can afford. Second, any firm that pays a substantial portion of its earnings as dividends is reinvesting less and can therefore expect to grow at a much lower rate in the future. Hence, there is a tradeoff between higher dividend yields and lower earnings growth in the future.
High-dividend paying stocks can be attractive only if dividends can be sustained. There are a few ways to check this. First, one can compare dividends to earnings. This ratio is called the payout ratio. A ratio of greater than 100% means that a firm paid out more in dividends than its earnings, which is unsustainable in the long-term. The Chart 3 below shows the proportion of firms with different payout ratios. There are a handful of them above a 100% , indicating that these firms pay out more in dividends than their earnings, a red flag for an investor wishing to invest in these companies since it is unsustainable for such companies to continue paying the same dividend in the long run. There are also a bunch of firms that had negative earnings and still ended up paying dividends. These are again early signs of future financial trouble that the company could run into.
Second, earnings are volatile so one needs to modify their approach by possibly looking at earnings over the last five years rather than just the last year. Lastly, one should also look at how much the company pays out in dividends and potentially how much they could. The Chart 4 below is an average of data compiled from the last five years which shows how much of earnings is paid out as dividends. There are a bunch of companies that pay dividends despite having negative earnings and a few whose dividends exceed earnings, both major red flags that investors should consider before investing in such companies.
The Table 2 below shows firms with the highest dividend yields (>6%) and payout ratios below 80%. These companies were filtered from a pool of over 700 companies. Only 13 companies met the criteria of having an average dividend yield of 6% or higher since the last five years along with an average dividend payout ratio of less than 80% since the last five years (DPS is Dividends per share whilst EPS is Earnings per share).
Comparing dividends to earnings is not sustainable in the long-run since earnings are not cash flows (accounting earnings differ from cash flows) and firms may have reinvestment needs. A potential way to measure cash flows available for dividends would be free cash flow to equity (FCFE). Free cash flow to equity measures cash left over after reinvestment needs are met. Table 3 shows firms with multiple criteria: A dividend payout ratio less than 80%, dividends per share not exceeding free cash flow to equity per share, and no negative earnings per share. There are 21 companies that meet the above criteria (FCFE/share is Free cash flow to equity per share).
Another tradeoff that was mentioned earlier was higher the dividend payment, lower the cash remains for reinvesting for future growth. Eventually, this means that there is lower growth in earnings. As an investor, one needs to accept this tradeoff if they are willing to invest in high dividend paying companies. Table 4 shows the growth rates of several of the firms mentioned above. The firms from above were filtered and only those having a payout ratio between 40% and 80% were selected since we wanted to see the effect of a medium to high dividend payout ratio on growth. Although several of the firms do have decent growth rates, they could have had a lot higher growth rates if not for the dividends that they paid out since that cash could have been additionally reinvested into the company for a higher expected future growth rate. Another point to note is that apart from a few companies, the general trend observed is that higher the dividend payout, lower the expected growth rate.
Overall, we can conclude that stocks that pay high dividends have historically delivered higher returns (albeit by a small margin) than the rest of the market. However, such stocks grow at a slower rate and are unable to sustain their dividends in the long run. As an investor, one should rather look for stocks that meet multiple criteria such as high dividends (dividend yields that exceed the treasury bond rate), sustainable earnings (dividend payout ratios that are less than a cutoff), and reasonable growth rates in earnings per share (EPS). Investing in such stocks would not necessarily give you the highest dividend yield, but the dividends are a lot more sustainable and the firms do have some growth potential. Lastly, another essential point to consider is that unlike a coupon payment on a bond, a dividend is not a promised form of payment. A firm is not obliged to continue paying dividends to its shareholders so one may run the risk of investing in a company which is unable to sustain its dividends and hence the firm could either decrease dividend payments by a certain percentage every year or altogether eliminate paying them in the near future.
By Arhan Parikh (arhan.parikh@xumitcapital.com)
