Motivating fact about investing in Dividend income stocks – If you had invested Rs 77,000 in ITC shares in the year 2003, today you would today have in excess of Rs. 18 lakhs if you kept reinvesting all dividends. (See explanation at the end of the post [1].

Factors considered:

  • Historic and current Dividend yield (1 year – 3 year – 5 Year).
  • Sustainability of dividend income.
  • Possibility of higher dividend payouts.

I am beginning to forget the number of posts I have written about investing for dividends.

To rationalize – “Over Time I have made more money in the form of dividends than I have as short, long or medium term profits”. In fact where I have reached with my portfolio now, I can dare the best of trader to achieve a higher return over the next 12 months than what I will get as dividends during the same period. The trader can start with the same amount of investment as I have made to acquire my dividend income stocks.

Let me explain. Sometime back we were looking at our best recommendations over the last 2 years. Many of the stocks returned over 100% in less than a year. These included stocks like Bharat Electronics, Hexaware, DCW, Ashok Leyland . . . . the list was endless. Thanks in part to the recent stock market boom, our actual returns look way to healthy to be true.

Now – I buy a little of every stock that we recommend. Last week when I wrote about my best stock purchase decision here, it surprised a few. In that post I had said that Noida Toll Bridge was one of my best stock picks of all times. Click on the link above to read the rest of that article. You will understand why it is almost impossible to earn a higher rate of return than what I am making in this stock.

The substance and spirit of that article was in finding a good stock at an outstanding price. Once you manage to do that, you will keep making money on that investment for a very long time. In case of Noida Toll, I purchased the stock at Rs. 21 at a time when its dividend yield was 4.74 %. Since the time of my purchase the stock has risen to Rs. 36. As expected, the company has increased its dividend payouts.

Noida Toll Bridge – Dividend Payout in absolute terms (in Rs.)

2011 2012 2013 2014
0.50 1.00 1.00 2.50

The current dividend yield for the company is 7.35 %. For me it is 12 %. On an acquisition / investment cost of Rs. 21, I am getting an annual dividend payout of Rs. 2.50, based on divided for FY 2014. Further, for the current FY 2015, the company has already declared an interim Dividend of Rs. 1.

Further, as the company grows further and generates more and more profits, its dividend payouts will increase further. Hopefully in 4-5 years I would have made Rs. 21 (my cost of investment) in the form of tax free dividends alone.

About Sustainability of Dividend Income

A lot of times when people ask me how to go about picking dividend stocks, they say it is easy in hindsight to suggest good stocks what about telling us a stock that will generate good dividend income in future.

Dividend Income – Stock Selection Criteria

While it is easy to pick up the top 10 (or top 50 or 100) dividend paying companies based on the current or historic dividend yield, the challenge is in finding companies which will sustain or increase their dividend yields in future.

Sometime back, there was a lot of noise around buying public sector bank stocks since their price had declined by over 50 – 60% in most cases. The hope was that they will continue to pay high dividends even if recovery takes some time. A lot of investors bought into these public sector banks. We had maintained that not only will they stop paying dividends in future but that their very survival is in jeopardy. Click here for the complete post. The relevant commentary from that article Dated April 2014 is produced below:

“How then do you select high dividend paying stocks? The ones which will continue to pay such dividends or better still increase them. For example, public sector banks have taken a beating over the last 2 years with the prices of most of them declining by over 50% and yet they keep paying high dividends. Many investors are now looking at these governments owned banking companies with fascination. The question is – are people opening any new accounts in these banks? Will their businesses prosper in future vis-à-vis their private sector peers? Or are you buying them hoping that they will keep dipping into their reserves endlessly to maintain their yields? Sure enough, an 8% tax free dividend for a government owned company is a screaming buy, but really, what about the longevity of such businesses in a competitive environment? Will the government be able to turn things around?”

I am not one bit surprised that most public sector banks have either not paid dividends this year or have reduced the yield to ~ 1%. Should you buy these bank stocks now? – Not even if you get them at a 50% discount from here, but that’s for another day.

  • High (current – 1-3-5 year) dividend yield coupled with a low dividend payout ratio – For sustainability of dividend payouts in future.
  • Dividend payout Ratio of less than 40%. Click here to understand the concept of dividend payout ratio.
  • Companies are well established with a strong financial history.
  • Stock prices have fallen either due to temporary business setbacks or unnecessary pessimism.

An analysis on the above parameters naturally requires going beyond historic dividend yields. Most importantly it will require a study of current market and corporate position before forecasting the possibility of a higher dividend yield in future.

To explain this point with the help of an example, take the case of Cairn India Limited – I have been accumulating this stock in my own portfolio.

Share Price Rs. 270
Current Dividend yield 4.64 %
Dividend Payout Ratio (DPR) 19.25%
Strengths
  • ~ 55k Cr. In accumulated reserves.
  • Zero debt on its books.
  • Operates in a sector critical for India’s progress. The Government has every reason to make sure that companies like Cairn should success.
Reason for recent stock price decline Oversupply of crude globally. Falling prices of petrol and diesel. Surprisingly – the fear that petrol and diesel will soon become very cheap or free?

Further, the management of the company has been under a lot of pressure to make higher dividend payouts ever since it took the extreme measure of extending a US $1.25 billion loan to its parent – Vedanta group for 2 yrs at Libor + 300 basis points. With the current LIBOR, this comes to ~ 3.5% p.a. Interestingly, prior to this the company had just done a buyback of equity from open market (in January 2014). At the buyback price of Rs. 335 a share, Cairn India could buy back ~ 2%. Usually, a buyback is announced when the Company believes that the share is quoting below its real worth, and it may be a good time buy back to increase shareholder value by reducing the number of issued share capital [2].

The problem if at all for Cairn India seems to be one of excess cash. The company seems unsure of what it can do with its cash reserves. In past the management has given indications of acquiring assets and exploration overseas. Either ways, Cairn will find it very hard to reduce its dividend yield and perhaps there is no reason why such a cash rich company should do so. Given that it has deployed cash at 3.5 % in its parent, investors are bound to question why not pay higher dividends? This does not take away from the fact that the company has excellent fundamentals and future prospects.