Buying stocks based on just their current dividend yield can be fraught with risk. Focus on dividend potential instead.

Investing in stocks for dividends is as old as the hills. Legendary investors such as Ben Graham used dividend yield to home in on out-of-favour stocks. Strategies such as the Dogs of the Dow (buying the stocks with the highest dividend yield in the index, every year) have worked well for Indian investors too. But buying stocks based only on their current dividend yield, without looking into their business prospects, can be fraught with risk. Especially for the long-term investor who wants to benefit from regular cash flows by way of dividends.

Will it last?

To start with, buying stocks purely for their current dividend yield can backfire if the company happens to be in a cyclical business. Take Varun Shipping. With a regular dividend payout of Rs 5 per share on a market price of Rs 50, the stock must have seemed a great ‘buy’ to any investor picking it up in April 2007. What could beat a dividend yield of 10 per cent?

But those who bought the stock then, would have reason to feel cheated today. Between 2007-08 and 2009-10, the company’s dividend rate plummeted from 50 to 8 per cent, as profits dropped by 90 per cent, buckling under slowing global trade. GE Shipping, Excel Crop Care, Prime Securities — the past five years throw up many instances of once-fancied dividend yield stocks falling victim to lower dividends owing to the cyclical swings in their core business. That suggests that, while selecting stocks based on yield, it is best to make sure the profits and dividends show a consistent or rising trend.

Where is BIZ headed?

Two, dividend yield strategies such as the Dogs of the Dow do not require the investor to understand the company’s business. But ignoring them can prove detrimental to your returns. India Card Clothing was one of the highest dividend yielding stocks in the market five years ago, paying out annual dividends of 125 per cent, translating into a yield of nearly 8 per cent in 2007.

But the fluctuating fortunes of the textile industry have led to high volatility in profits of this company too.

Its annual dividend payouts have declined from 125 per cent to 30 per cent over five years, even as the stock price has tumbled from Rs 180 to Rs 115. That’s a double whammy for investors in the stock.

Focussing instead on a company with a lower dividend yield, but with more attractive prospects, may have yielded far better results.

Is the payout too high?

A third factor that a dividend-seeking investor must pay attention to is the proportion of profits that a company distributes as dividend. This payout ratio, if low (ideally below 50 per cent), provides a margin of safety to investors.

A high payout ratio may be the sign of a company that is keen to reward shareholders, but if profits suffer a blip, it puts dividend payouts under pressure too. Thin margins and a fluctuating rupee make for rather fluid business prospects for HCL Infosystems. The company is a generous dividend payer and the stock sported a dividend yield of about 4 per cent barely three years ago. The company has also steadily raised its dividend rates from 325 to 400 per cent over a three-year period.

But with the payout ratio hovering at about 100 per cent now, dividends are vulnerable to any blip in profits.

So how can one select stocks with good dividend prospects based on the above criteria? Simple.

Look for companies in non-cyclical businesses. They must combine rising profits and dividends and yet have payout ratios of less than 50 per cent. That leads us to the accompanying list.

Read also: Price gains hard to come by? Bet on dividends

(This article was published on July 21, 2012)
XThese are links to The Hindu Business Line suggested by Outbrain, which may or may not be relevant to the other content on this page. You can read Outbrain's privacy and cookie policy here.