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India Infoline's fund scheme focuses on dividend yield—a dated and flawed concept

High dividend yields are not really indicative of anything. Yield and book value of share as measures of under- and over-valuation of shares are a throwback to the ‘60s and ‘70s that don’t have much relevance anymore

India Infoline Mutual Fund is launching the IIFL Dividend Opportunities ETF-an open ended Index Exchange Traded Fund based on high-dividend yield stocks. Should you consider investing in it?

The investment objective of this scheme is to provide returns (before fees and expenses) that closely correspond to the total return of the CNX Dividend Opportunities Index. The decisive factor for the selection of companies to be a part of this Index would be dividend yield-which does not make great sense.
Moneylife is not a great believer in chasing high dividend yield stocks, except on some rare occasions and these are all too fleeting. Indeed, dividend yield and book value of share as measures of under- and over-valuation of shares are a throwback to the '60s and '70s that don't have much relevance anymore. The idea of using dividend yield as a tool for valuation was pioneered by John Burr Williams (1900-15 September 1989), in his Discounted Cash Flow (DCF) based valuation, and in particular, dividend-based valuation, called the dividend discount model (DDM). It is a procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued and vice versa. This was relevant at a time when equity prices were low because not much of savings were headed for equities.

It was also the time when companies were conscious of paying regular dividends since it was the only way of compensating shareholders. But three factors have changed this:

1. Rise of the equity cult: For the past two decades at least, attitude to equities has changed dramatically. Investors have started recognising equity as a
wealth-creating asset class. And at the same time, global capital flows have surged in search of undervalued equity assets. With the huge rise in capital flows around the world starting from the early '80s, which became a flood from the '90s, equity values as a whole have gone up. A larger share of global savings has flooded into equities, taking them higher for the same level of earnings and dividends. This has meant that dividend yield has automatically fallen without a change in fundamentals. This makes dividend yield less relevant today. Some of the finest stocks will sport a low dividend forever even as they keep rising. A case in point is Asian Paints—which carries a dividend yield of just 1%.

2. Dividend has competition: The days when profit-making companies would be obliged to pay dividend as an obligation, is over. In today's market, companies have other options of giving returns to investors. For instance, through buyback of shares. This would increase the overall wealth of the company's investors, as the total number of shares decreases, leading to higher earning per share. This is also a tax-efficient way of providing returns as dividend was taxable until a few years ago and now attracts dividend distribution tax for companies. The fact is that many companies have a policy of never paying dividends. Bill Gates at Microsoft and Warren Buffett at Berkshire Hathaway (the two richest CEOs in the world) are the two best examples of this policy. A person going by dividend yield would never buy these stocks.

3. Low dividend could be a trap: Buying high dividend yield stocks can pay off but think about this. A low dividend yield stock will mean low stock prices for a company that is earning good profits and paying out good dividends. Why should the stock price of such a company be low? Smart investors are scouting around for precisely such companies—high profits and low price. Why are then stocks with high dividend yields shunned? This is simply because stocks are priced as per their future earnings growth. If a stock has paid high dividend it certainly means that it has had a good year. But if the price is low, it means that investors don't think it has a great future. It could well be that what you gain by higher dividend, you lose in terms of price.

Hence, the product design of the India Infoline scheme is inherently flawed. Maybe some investor would bite because of the current interest in interest and yields. But remember—equity mutual fund schemes are really tools for capital appreciation over a long period of time. High dividend stocks are not the best choices for that.

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COMMENTS

isaac

5 years ago

Being a small investor, I was extremely positive & was awaiting the launch of this ETF, however after reading your analysis i was forced to re-analyze. A quick comparison on the last 1 year capital appreciation returns of cnx div. index vs nifty index confirms that the story is still positive for me, now i await to watch the expense ratio, tracking error and DDT impact on this ETF, thanks for bearing with my comments, all the best & happy investing.

Narendra Doshi

5 years ago

Well argued. It does make big sense,indeed.

Global cues indicate soft opening for Indian stocks: Thursday Market Preview

The domestic market is following global markets, besides the indices are still reeling from the RBI’s rate hike

Indian stocks are likely to see a gap-down opening on dismal global cues. Economic and debt issues pulled the US markets down on Wednesday, closing at its worst in eight weeks. Volumes increased as selling intensified, indicating that investors are holding back their purchases in the market. Markets in Asia were lower in early trade today on the US debt stalemate. The SGX Nifty was 58.50 points down at 5,489.50 against its previous close of 5,548.

The stock market slipped a little further on Wednesday, following the cautious outlook expressed by finance minister Pranab Mukherjee and indications of more monetary tightening to come, after the Reserve Bank of India's surprising 50 basis points rate hike on Tuesday.

The market bounced back in initial trade, ignoring concerns about the US debt crisis that capped most Asian markets. The Nifty opened at 5,589, up 14 points from its previous close, and the Sensex resumed trade 53 points higher at 18,571. The benchmarks rose to their day's high early on, with the Nifty at 5,592 and the Sensex at 18,579.

However, in choppy trading the market lost the early gains and the indices fluctuated on either side of the neutral line. Selling pressure in mid-morning trade resulted in the market going southward. Capital goods, power and realty sectors were under pressure.

The indices slipped to their intra-day lows in noon trade, the Nifty to 5,522 and the Sensex to 18,359. There was a marginal recovery in subsequent trade, but the gains were not sufficient to pull the indices out of the red.

The Nifty finally closed 28 points down at 5,547 and the Sensex closed at 18,432, a loss of 86 points. The losses were not as severe as Tuesday’s 105-point drop, but volumes were more or less the same again today. We expect the Nifty to fall up to the 5,495 level.

Wall Street closed lower overnight us lawmakers failed to reach a consensus on increasing the debt ceiling ahead of the 2nd August deadline. S&P, Moody’s Investors Service and Fitch Ratings have said they may downgrade the US’ top AAA rating if lawmakers fail to find a solution.

Stocks retreated further after the Federal Reserve said the US economy grew at a slower pace in more parts of the country since the beginning of June as shoppers restrained spending and factory production eased.

In stocks, United Technologies declined 2.83%, General Electric fell 2.42% and Caterpillar tumbled 3.67% in trade. On the other hand, Boeing gained 0.67% after it reported a 20% jump in earnings.

The Dow tumbled 198.75 points (1.59%) at 12,302.55. The S&P 500 Index declined 27.05 points (2.03%) at 1,304.89, its worst daily percentage decline since 1st June. The Nasdaq slipped 75.17 points (2.65%) at 2,764.79.

Oil prices fell on Wednesday as data showed the first release of crude from the US petroleum reserve pushed up domestic inventories last week. US crude for September delivery fell $2.19, or 2.2%, to settle at $97.40 a barrel, after sliding to an intra-day low of $97.28. In London, ICE September Brent settled at $117.43, down 85 cents, falling from the day's high of $118.50.

Tracking the decline in the US, markets in Asia opened weak on Thursday. Besides debt issues, a decline in durable goods orders in the US also weighed on investor sentiments. Among exporters Canon declined 1.4%, Sony fell 1% and Toyota Motor slipped 1.8%. Concerns over a stronger yen also weighed on Nissan Motor, which fell 1.1% despite stronger-than-expected first-quarter earnings.

The Shanghai Composite fell 0.88%, the Hang Seng declined 1.07%, the Jakarta Composite slipped 0.96%, the KLSE Composite was down 0.67%, the Nikkei 225 tanked 1.12%, the Straits Times declined 0.68%, the Seoul Composite fell 0.80% and the Taiwan Weighted shed 0.35%.

Back home, the Securities and Exchange Board of India (SEBI) board in its meeting later today is likely to accept only part of the Achuthan panel report on the new takeover code, said a senior official. The board meeting is expected to clear the guidelines for infrastructure debt fund and come out with a new company takeover code.

Besides, a uniform Know-Your-Customer (KYC) norm that would be applicable on all market players is also likely to be cleared by the board, chaired by SEBI chairman UK Sinha.

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