Equity that looks like debt


Director, Banyan Tree Advisors

December 20, 2011

A surefire way to pick up cheap stocks is to look at dividend yields. They give you an assured annual income and adequate downside protection.

IF YOU’RE one of those gentlemen who prefer bonds — and god knows there are enough of them out there — you perhaps consider the equity market to be a satta bazaar where thousands lose or win money depending on which way the stock
they picked went. If so, you’d rather not bother with all this nonsense and instead invest only in fixed deposits and bonds that assure you a regular annual income. But if you’ve even a teeny-weeny appetite for risk, what I have to say now may
surprise you. A sure-fire way to identify really cheap stocks is to look at dividend yield. For, you see, when you take this path, you are buying the stock not in the hope that it will appreciate in double-quick time. Instead, you invest in it to get a
regular annual income, while simultaneously giving yourself adequate protection on the downside.

Dividends spell cash flows. Why are dividends so important? Simply because a healthy dividend payout indicates that the company is generating cash flows. While earnings numbers can be manipulated, a company can pay out dividends only from the cash it generates: no company would like to give away cash it has not earned. For the shareholder too, dividends count as real money — as opposed to notional gains.

Dividend yield is the dividend per share divided by the price of the stock. This represents the annual rate of return a stock would provide on the basis of its dividends alone; in many ways, it is akin to the interest rate on a fixed-income
instrument, such as a bank deposit or a bond. A dividend yield higher than the post-tax yield on a fixed-income instrument (7-9 per cent) is, no doubt, attractive to the value investor. But there’s a catch: what if you get your dividend, but the stock itself falls in value? Here’s what you need to do to ensure that you’re on a safe wicket:

Make sure the company you invest in will continue to be in business for the foreseeable future. Check if it can maintain the current rate of dividend, measured as dividend per share. It is very important that you ensure that these conditions are met; otherwise, a ‘safe’ investment could well turn hazardous and may result in almost all your invested capital being wiped out. In that sense, a dividend yield stock can be compared to a junk bond. Michael Milken proved, way back in the 1990s (before he was ensnared in his own tangled web), that junk bonds, if bought sensibly, provide superior returns with lower risk than AAA bonds. Chew on that!

Here are a few more pointers that can help you steer clear of dangerous investment waters.

Are the accounts true? You must have good reason to believe that the company’s annual report is fair and true. While this caveat holds true for all investments, it is particularly so for this category of stocks. A high tax rate is usually a good pointer to companies that are not fudging their numbers.

Dividend-paying record. The company should have an uninterrupted record of dividend payout for the last 5-10 years. The longer the dividend-paying record, the lower is the possibility that the company will skip a dividend in the coming years.

Could a downturn in profits affect you? Take a hard look at the dividend payout ratio (the dividend per share divided by the earnings per share). If a company is distributing a high proportion of its earnings as dividends, a negative swing in
profits may compel it to reduce the dividend per share, thus reducing your rate of return.

No limit set by the taxman. The dividends you earn do not attract any tax because the company pays a 20 per cent tax on the amount it distributes as dividend. And there’s no limit on the amount you want to invest, unlike the limit in respect of
investments in most schemes floated by the government.

Advantage small investor. Although such opportunities may on occasion arise in stocks with a large market capitalisation, the retail investor is sometimes the only player in the market who can make use of these opportunities because the volumes in these scrips are too low to attract large investors. This is one area where being small is an advantage.

It can’t get much lower than this. If you buy a stock at Rs 20 and the dividend on the share is Rs 3 per share, the dividend yield works out to 15 per cent. If the stock falls, say, to Rs 15, the dividend yield would increase to 20 per cent. If you’ve chosen the company carefully, the stock could provide an attractive opportunity, either to you or to some other market player, ensuring adequate downside protection.

And there’s a decent upside. When the market discovers a dividend play, it usually bids the stock up as investors pile on in the hope of making safe, tax-free returns. This happens especially as the record date for dividend draws nearer. But even if the stock is bid up to Rs 30, its dividend yield will still be an attractive 10 per cent, giving you a return of 50 per cent on the purchase price of Rs 20.

Diversify. You need to ensure that you buy a diversified basket of such stocks because one out of 10 dividend plays may just go bust, no matter how good your research. This is a rule to follow religiously when buying value stocks. Ben Graham, from whom there is much to learn, is known to have had more than 100 stocks in his portfolio. There is of course no compelling need for a retail investor to resort to such widespread diversification in his portfolio; even so, it is wise not to invest more than 10 per cent of your money in a single value stock.

There are a number of attractive dividend plays in the market (See Sideshow: The money-spinners). One interesting case that comes to mind is that of ICICI which was trading at Rs 40-45 in March 1999, providing a dividend yield of 17-19
per cent. While there were few takers for the stock at these levels, a large investor base was happily lapping up its bonds issue at a pre-tax return of 14-15 per cent.

Clearly, either the bond market or the stock market was wrong, and anyone who was able to read the confused signals would have cashed in (for more on this, follow this link). The ICICI stock did not test the Rs 40-45 level for the next 20
months, and currently trades at about 100: this offers striking testimony to the downside protection in buying stocks at high dividend yields. Purchased at Rs 40-45, the stock would today have yielded 100 per cent appreciation, besides tax-
free dividends! Easy money, I call it.