Investing In High Dividend-Paying Stocks

Investing in high dividend-yielding stocks is considered to be a strategic way to make a reliable and regular source of passive income to build wealth. Armaan Madhani explains how and why, fundamentally strong and consistent dividend-paying companies can be sound value bets for investors in the long run 

Capital appreciation has always been the blue-eyed boy of investment returns. Dividend earned on equity investments plays a second fiddle role and therefore usually gets ignored. The rally in domestic equity markets over the last two and a half years has led many novice investors to surmise that return from equity investment primarily comes from an increase in share prices. They consider dividends to be a miniscule cherry on the cake that barely contributes to the overall value that is created over the investment horizon. 

This assumption might be true to some extent, particularly in the shorter period and that too during a bull run. However, in the longer run, dividend plays an equally important role in terms of the potential return an investor obtains from an investment in equities. High-quality and consistent dividendpaying companies have always been looked upon as sound value investment bets by investors across the world for decades. 

Investing in high dividend yielding stocks is considered to be a strategic way to make a reliable and regular source of passive income to build wealth. Unlike earnings, dividends can’t be manipulated and moreover they also help preserve the purchasing power of investment capital, particularly in cases where inflation is on the rise. No wonder John Bogle, the founder of the Vanguard Group and the father of index investing, would frequently say, “Dividends are an investor’s best friend.” 

Dividends Can Make You Rich

Dividend investing is a strategy of buying dividend-paying stocks to generate wealth by reinvesting their dividends back into the same stocks. By doing so, investors get two sources of potential profits, namely, the income from dividend payments disbursed by companies and capital appreciation of stocks over time. The importance of dividends over the long term can be gauged by a comprehensive study conducted in the US and the UK stock markets from 1900 to 2000 by Elroy Dimson, Paul Marsh and Mike Staunton. 

They found that a market-oriented portfolio that included reinvested dividends would have generated nearly 85 times the wealth generated by the same portfolio relying solely on capital gains. This wealth accumulation would, of course, have been lower if the dividends were not assumed to have been reinvested. Let us analyse the compounding snowball effect of dividends and their reinvestments for some Indian companies that have a consistent dividend-paying policy. 

Hypothetically, if you had invested ₹ 66,700 in shares of HDFC at the beginning of FY05, you would have earned ₹ 32,600 in dividends alone till the end of 2013, which is almost 50 per cent of your investment. This might not look exciting as the annualised returns come to just about 5 per cent. Although this return is lower than the prevailing inflation rate at that time, the twist in the story comes if you would have reinvested the dividends in the same stock. In that case, the annualised returns would have almost doubled to 9 per cent. The returns would have been greater had we considered a longer duration. 

Consider this: If you would have invested ₹ 2,625 in the shares of Balmer Lawrie and Co. (an Indian Mini Ratna PSE under the Ministry of Petroleum and Natural Gas) at the start of FY02, you would have earned ₹ 18,750 from dividends up till FY14, having recovered your cost of investment in the first seven years only through dividends. However, in case of reinvestment of dividends, the payback time reduces by one year. Moreover, in this case almost a quarter of the total return comes from dividends. What is important to note is that as we extend the study period, the share of dividend income increases in weight and plays a more vital role in the total returns. If you stay invested in a counter over a fairly long period of time, corporate actions such as stock splits and bonuses further enhance the value of dividends that you receive over a period of time. 

Significance of Dividends

There are various empirical studies which suggest that stocks paying higher dividend have historically delivered higher risk-adjusted returns. In a study by New York-based Global X Funds for the period 2003-12, it was found that stocks that paid dividends outperformed those that did not and this outperformance generally increased as the dividend yield increased. It goes further and states that dividend paying stocks have lower risk, according to a myriad of risk measures, in comparison to non-dividend paying stocks. 

A company’s commitment to pay consistent dividends indicates the management’s priority on returning cash to shareholders. It also helps the management stay focused on the core business, preventing them from undertaking unnecessary diversification or aggressive over-priced acquisitions.It has conventionally been observed that high and sustainable dividend-yielding stocks often tend to be mature and stable companies that experience fewer gyrations in their stock prices. 

The reason for lower volatility in such stocks relative to securities that yield low or no dividends is due to the fact that the stock is, in effect, ‘yield supported’. It means that once the price of a high dividend-yielding stock falls, the dividend yield rises again. This makes the stock more appealing for investors, which in turn, helps buoy the share price. Correction in stock prices also furnishes a golden opportunity for existing equity holders to reinvest their dividend payouts and boost overall returns. 

Look out for Dividend Yield

Investors should look for dividend yield instead of dividend amount while choosing dividend-paying stocks. Dividend yield is a ratio that helps investors understand how much dividend a company pays out each year relative to its stock price. The formula for the dividend yield is Annual Dividend | Share Price ×100. This ratio is an excellent way to compare the dividend-paying capability of different companies. 

High Dividend Yield isn’t Everything!

All dividend-paying stocks are not equal and it is important to separate chaff from grain. Investors should keep in mind that higher dividend yields do not always indicate attractive investment opportunities because the dividend yield of a stock may be elevated as the result of declining stock price owing to deteriorating earnings, also known as a dividend yield trap. Often stocks that have an unusually high dividend yield than their peers are a sign of trouble, not opportunity. 

Any stock that yields a dividend higher than 6-7 per cent should be analysed thoroughly with a lot of scepticism.Also, the fact that a company is distributing huge chunk of its cash to shareholders signals the lack of investing opportunities for the company, indicating growth hurdles in the future. There have also been instances in the corporate world where companies have borrowed money just to maintain their higher dividend payouts. Clearly, such companies should not feature in an investor’s long-term investment portfolio. 

The Winning Strategy

Investors should focus only on those companies that not only have attractive dividend yields but also have sufficient additional cash to maintain and grow their businesses. This is particularly reflected by cash used to pay dividends as proportion to the earnings or the dividend payout ratio. Sometimes, it is better to buy a dividend stock with a lower yield that is rock solid than to chase a high yield that may prove illusory. The company’s fundamentals, growth drivers, capex plans, leverage, consistency and sustainability dividends and dividend growth rate are equally important parameters that should be considered. 

One of the best ways to identify good quality stock-paying dividends is to study the history of dividend payouts. Consistent dividend-paying companies that keep increasing their dividend in terms of percentage are perfect for investments. Increasing dividends or the growth in dividend per share (DPS) can be considered a sign of financial strength. While choosing dividend stocks, investors can screen companies by carefully scrutinising the historical growth in earning per share (EPS). 

There is enough research available which indicates that the companies that initiate or increase their dividend consistently outperform not only other dividend paying stocks but also key benchmark indices in the long run.To ensure that companies are not paying dividends that are unsustainable in the long term, investors can turn a blind eye to those companies whose dividend payout ratio is more than 70 per cent. A higher than normal dividend payout tends to typically indicate a higher probability of a dividend cut or a lower probability of dividend sustainability. 

In analysing dividend payout ratios, investors should compare the ratio to the average ratio for the industry within which a company operates. In making a qualitative judgment about a company, stable or increasing dividends are typically looked upon favourably. Investors can also make use of the FCFE coverage ratio which considers not only dividends but also share repurchases. FCFE is the cash flow available for distribution to stockholders after working capital and fixed capital needs are accounted for. A FCFE coverage ratio significantly less than 1 is considered unsustainable. 

In such a situation, the company is drawing down its cash reserves for dividends and repurchases. A high dividendyielding company being analysed should have a strong balancesheet with ample liquidity, regular free cash flows and low leverage. In addition, such businesses should either hold strong pricing power or formidable barriers of entry or defensive moats in order to sustain earnings growth and thrive in the long run. Caution should be exercised on the valuation front while investing in high dividend-paying securities. 

Following is a list of filtered Large-Cap, Mid-Cap and Small-Cap stocks that have reported high, increasing and sustainable dividend payouts on a consistent basis along with high liquidity and minimal leverage.

Conclusion

In order to win a cricket test match on a difficult pitch, a team needs a calm batsman with an impeccable talent who is solid in defence. Similarly, when equity markets undergo tough times as a consequence of high inflation, tightening monetary policy, slowing growth, weak global cues, recession and so on, investors should position themselves in a defensive stance. A simple strategy to establish a defensive stance is to buy and hold defensive stocks that pay dividends regularly. This strategy not only safeguards investors when the market nosedives, but also supports portfolio returns when the market rallies in the long run. Above all, an investor with a goal of creating wealth via investments in high-quality, consistent dividend-paying stocks should have a long-term investment horizon and plentiful patience. 

Stock Recommendation 

SWARAJ ENGINES LTD. 

CMP (₹ ): 1699.45 

BSE CODE: 500407
Face Value(₹ ) : 10
52 Wk High/Low : 1,800.00 /1,292.55
Mcap Full ( ₹  Cr.) : 2,063.89 

Swaraj Engines Ltd. (SEL) was promoted by erstwhile Punjab Tractors Ltd. (since merged with Mahindra and Mahindra Ltd.) and Kirloskar Oil Engines Ltd. in 1985. Diesel engines with power outputs ranging from 22 HP to more than 65 HP are manufactured and supplied by SEL. The business has specialised quality analysing equipment that is highly productive and accurate. It is also manufacturing high-tech engine components. Over 100,000 engines have been provided by SEL to date for installation in Swaraj brand tractors.

The plant of Swaraj Engines has the facilities to produce any model of Swaraj product mix. It is also equipped with the latest high-tech machines. Moreover, it has ergonomically friendly material handling system like MMC, etc. The plant is also equipped with 66 KVA sub-station for preventing power interruptions. SEL is a manufacturer of diesel engines and high-tech engine components. Diesel engines are specifically designed for tractor application. The company’s shares are traded on the National Stock Exchange of India Limited and BSE Limited.

For the first quarter that ended on June 31, 2022, Swaraj Engines reported net sales of ₹ 398.35 crore. This is a rise of 26.58 per cent over the net sales reported same time last year. Likewise, the operating profit also saw a rise of 15.8 per cent in the recent quarter. The operating profit climbed to ₹ 57.83 crore from ₹ 49.94 crore in the first quarter of FY21. The company also reported positive quarterly net profit of ₹ 39.54 crore as compared to a net loss of ₹ 33.65 crore in the previous year same quarter, representing a rise of 17.5 per cent.

Besides, the company’s annual financials reveal that its net sales climbed to ₹ 1,138.15 crore in FY22 from ₹ 986.57 crore in FY21, giving an increase of 15.36 per cent. The operating profit zoomed by 14.41 per cent to ₹ 165.04 crore in FY22 from ₹ 144.25 crore in FY21. Similarly, the net profit for FY22 stood at ₹ 109.47 crore, delivering an exceptional return of 18.29 per cent from ₹ 92.54 crore reported in the past year.

The strong rabi agricultural harvest, preliminary predictions of successive normal monsoonsand adequate financing options are likely to support the pace of demand for tractors. Further, the government’s continued thrust to enhance farmers’ income through various initiatives like improving irrigation facilities, crop insurance, periodic revision in minimum support price (MSP), monetary support to marginal farmers and promoting rural development besides other industry growth drivers such as agricultural mechanisation and momentum in infrastructural projects, etc. are likely to promote growth.

In the medium to long term, it is anticipated that the tractor industry would continue to prosper. The company’s engine business is likely to move in perfect synchronisation with the industry given this background. SEL recorded its best-ever quarterly performance in both engine sales volume and profit on the back of strong engine demand. Registering a sales volume growth of 13.9 per cent over the same period last year, the company posted engine sales of 38,428 units (last year 33,747 units) – the highest ever for any quarter.

Even while margins were affected by the rise in commodity prices, the effects were greatly reduced because of enhanced operating cost management and the advantages of cost spread on increasing volume. On a cumulative basis, the company once more recorded its greatest annual engine sales, up 3 per cent to 116,811 units from 113,269 units shipped in FY21. For the first time, net operating revenue exceeded the 1,000-crore barrier and was ₹ 1,138.15 crore. The company is almost debt-free.

The dividend provided by the stock is around 4.70 per cent. The dividend payout ratio of the company is very healthy and positioned at 82.5 per cent. The company has a good track record of delivering impressive ROE which stands at 34.3 per cent. The stock PE is 17.8 which means it very attractive at this price. The net profit has been witnessing a consistent increase for the past three years. The same can be seen in case of the share of foreign institutional investors and retail investors that has been increasing on a year-on-year basis. Hence, we recommend BUY. 

COAL INDIA LTD. 

CMP (₹ ): 230.95 

BSE CODE: 533278
Face Value(₹ ) : 10
52 Wk High/Low : 241.85 / 139.20
Mcap Full ( ₹  Cr.) : 1,42,328.21 

Coal India was incorporated in 1973 as Coal Mines Authority Ltd. after the nationalisation of the coal sector. It is a ‘Maharatna’ company under the Ministry of Coal, Government of India. It is the single-largest coal-producing company in the world with operations spread across eight states in India. Coal India leads the country’s coal production, contributing to around 80 per cent of the nation’s entire coal output. Its supplies to the power sector exceed 80 per cent of its entire despatch. The board of CIL and its subsidiary company has approved 16 mining projects in FY 2021-22 having a sanctioned capacity of 99.84 MTs per year.

These projects will start contributing in the ensuing years. In FY22, five mining projects having a capacity of 12.60 MTs per year have been completed. During FY22, the total volume of coal and overburden handled by CIL was about 1,733 million cubic metres. The overall system capacity utilisation of CIL thus worked out to be about ~77 per cent. The company’s product offerings include coking coal, semi–coking coal, non–coking coal, washed and beneficiated coal, middlings, rejects, CIL coke, tar, heavy oil, light oil, soft pitch, and other value-added products.

The company’s physical performance during 2021-22 scaled to a remarkable all-time high, creating multiple records in production, off-take, despatches to the power sector and over burden removal (OBR). Turning out a strong financial performance as well, its gross sales, net sales and capital expenditure have been the highest ever in 2021 with profit after tax being the secondhighest during the year since the inception of the company. Most subsidiaries of CIL have chipped in with their best performance to date.

Those who could not clock growth have still performed commendably amid their own local problems and challenges. The company’s quarterly standalone financials indicate that net sales for Q1FY23 were at ₹ 32,497.98 crore as compared to net sales of ₹ 23,293.65 crore for Q1FY22, recording 39.51 per cent growth. Operating profit for Q1FY23 stands at ₹ 13,245.35 crore with rise of 139.74 per cent. The net profit has also been on the higher side and stands at ₹ 8,858.21crore since the same period last year which was at ₹ 3,175.23 crore, a jump of 178.98 per cent.

The annual performance of net sales is at ₹ 100,623.37 crore for FY22, which has increased by 21.66 per cent from last year’s figure of ₹ 82,710.32 crore. The operating profit in FY22 stood at ₹ 28,595.03 crore as compared to ₹ 22,372.30 crore for FY21. The company has reported a substantial net profit of ₹ 17,387.01 crore for FY22 as compared to profit after tax of ₹ 12,705.14 crore for FY21, reflecting growth of 36.85 per cent. During FY22, the company incurred a capital expenditure of ₹ 15,400 crore. It was fully funded through internal resources and was driven up by many developments like accelerated HEMM procurement process, land acquisition, coal evacuation initiatives, rail infrastructure strengthening, timely contract finalisations and execution, joint ventures, etc.

The capex target of CIL is ₹ 16,500 crore for FY23. The 35 FMC projects will require large investments. Phase II of the FMC project implementation includes nine more projects and related rail infrastructure. Further, land acquisition must be done continuously. The company is keen on minimising the carbon footprint of its operations and taking care of the environment. In an effort to become a net zero entity, it is aiming at installing 3,000 MW solar projects by FY24. Work orders for 240 MW have been awarded in FY22.

Additionally, it is focusing on fully automated and environment- friendly coal loading by setting up coal handling plants and silos. CIL is facing pressure to increase its production on the back of demand increase and reduction in generation by imported coal-based plants. Further, CPPs have also stopped importing coal and generating power and such industries are now procuring power from the grid. This may result in an increase in the e-auction prices.

CIL has maintained its 700 MT production target for FY23. Recently, CIL’s production increased by 44.6 million tonnes (MTs) in just five months and four days of the ongoing fiscal as of September 4, 2022 eclipsing the previous best of 44.5 MTs registered in FY 2016, which though was for the entire year. The record milestone was achieved when CIL’s progressive production touched 259.6 MTs on September 4 of the current fiscal, compared to 215 MTs as of same date last year. Hence, we recommend BUY. 

(Closing price as of Sept 16, 2022)