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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.