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Stock Dividends
Dividends reflect a company's confidence about its performance, but investing solely in dividend paying stocks is not a wise investment strategy.
Over the past decade, since January 2004, Nifty has offered a compound annualised total return of 16.3%. Of this, 14.6% came from capital appreciation, while a mere 1.7% came from dividends, assuming they were reinvested. Over the same period, the Dow Jones Industrial average has provided a compound annualised total return of 7.7%, of which, close to 3% came from dividends.
These examples point out that in a rapidly growing economy such as India, dividends are not as important for building investors' wealth as capital appreciation, particularly, when the markets are bullish. This is in stark contrast to developed economies, where dividends contribute significantly to investors' returns.
The contrast can be easily explained by comparing the GDP growth rates in emerging and developed economies. In emerging economies, higher GDP growth rates offer a greater growth potential to companies. Hence, the management prefers to retain a larger share of profits for investing in the firm's growth than paying out dividends. In a growing economy, new opportunities abound. The firm needs cash to explore them.
Are dividends of no importance?
In addition to being a means for distributing profits, dividends are, importantly, a way of sending a powerful message to shareholders about the company's performance and its prospects. It gives them an insight into the management's thinking vis-a-vis the business.
Therefore, a dividend pay out policy is a very sensitive affair. This is also a key reason one does not easily find a dividend-paying company cutting back on its pay outs. Regular dividend pay outs also bring in an element of discipline in the cash budgeting of the company. Finally, it is easy for investors to appreciate the value of a company that pays regular dividends. Thus, among two companies that have established businesses, a reasonable history and a regular cash flow, a company that pays dividend consistently stands a better chance of inspiring confidence among investors.
If we were to construct an equal weighted index of Nifty stocks--established companies with a reasonable history--that have consistently paid dividend in the past five years, with dividend pay outs increasing with each subsequent year, such an index would have generated a compound annual growth rate (CAGR) of close to 18% over the past 10 years. The Nifty's CAGR stands at 15%. Moreover, these additional returns would have come almost at the same volatility as the Nifty, implying a higher risk-adjusted performance.
However, saying that consistent dividends are mandatory and sufficient for superior, risk-adjusted returns will not be accurate. If investors limit their exposure to dividend-paying companies, even the ones paying dividend consistently, their investment universe will become very restricted. Such investors will miss out on many wonderful companies that redeploy their cash in growth opportunities available to them. Also, paying out a higher proportion of earnings as dividends could lead to erosion of shareholder value in the long term. This may be because of rationalisation in valuation ratios--PE and PB--which take future growth in earnings and book value into account. Finally, the dividend pay out policies of companies are also governed by the tax regime in the country. In India, companies have to pay dividend distribution tax (DDT) to the government on the total dividend paid to the shareholders. However, there is no tax on long-term capital gains from equities. Since the cash paid by the company as DDT effectively reduces its intrinsic value, one may argue that paying dividends is an inefficient way of increasing shareholder wealth. It would be more beneficial to redeploy the cash in the business, improve the stock price and let the shareholder benefit from accumulating long-term capital gains without any tax implication.
To conclude, apart from being a source of income, dividends also play an important role as a tool for doing stock analysis. Dividends reflect the management's view of the company's future. However, relying on a simple strategy based only on dividend-paying stocks shall not be to the investors' advantage.
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