A high dividend yield does not make a stock a good buy. Here’s a five-step approach to select the best in the basket.

With the stock market going nowhere, capital gains on stocks are getting harder to come by. At such times, stocks that provide regular dividends become the darling of savvy investors. Such stocks — which provide high dividend yields (ratio of dividend to market price) — are perceived as a hedge against volatile markets of the kind we are seeing today.

For investors in stocks that distribute dividends, the payouts form a source of regular income — akin to interest on debt instruments. Also, dividends received by shareholders are tax-free in their hands.

And of course, when the market turns around, there’s always the possibility of capital appreciation, too.

The checkpoints

The textbook approach to selecting dividend yield stocks is to pick an index, sort its constituents by dividend yield and buy the ones with the highest yield.

But there are risks to this approach. A high current dividend yield from a stock does not automatically make it a good buy. That’s why we recommend a five-step approach to selecting a dividend yield stock.

# 1 Assess whether the dividends are one-off. The company must have a consistent track record of paying dividends at a respectable rate.

# 2 Check whether the dividends are sustainable. Is the current dividend rate high because of a one-off special distribution? You are interested in future dividends, not past record.

# 3 If the dividend yield looks good because the stock price has declined, ask why. Is it because of factors which are affecting the entire market or the sector, or is it due to company-specific reasons which may continue to be a drag on the stock. If it is the latter, you may be better off keeping away from the stock.

# 4 Check whether the company has a fundamentally sound business with a fair record of growth in sales and profit. Prospects matter, if a company is to keep up dividend payouts. Companies with exceptional or windfall items in their profit may not be able to keep up their dividend payouts in the future.

# 5 Remember, even good companies may encounter difficult times. So, see whether the company has the cushion to sustain dividends at the current rate, if profit declines. The dividend payout ratio (dividend per share/earnings per share) is the best way to gauge this. This metric shows the extent of profit a company usually distributes as dividend. A company with a very high dividend payout ratio, say, above 60 per cent, may not be able to sustain the current levels of dividend if profit falls. Companies with moderate payout ratios will be able to do so.

Finally, it may be not be a good idea buying stocks of small companies which meet the criteria listed above. A dividend yield investment strategy is relatively conservative, and companies with small market capitalisation, say, below Rs 100 crore, may be more vulnerable to business vagaries and price shocks.

With the rules clear for homing in on dividend yield stocks, we decided to apply them to the listed universe. We ran screeners based on the above parameters to come up with stocks that seem good dividend yield picks (see table).

The PSU pack leads

Public sector entities, nudged by the government — their largest shareholder — have traditionally been good dividend payers. Not surprisingly, they lead the dividend yield pack. With the government looking to shore up its finances in a difficult economic scenario, dividend flows should remain healthy as they were last year.

Oil and gas explorer Oil India, whose prospects have improved with fuel pricing reforms and the recent government move to hike gas prices, yields 5.6 per cent. Tourism Finance Corporation, controlled by public financial institutions and banks, yields 5.3 per cent, has paid dividends and grown profits consistently, and trades at an attractive valuation (around 3 times price-to-earnings).

Balmer Lawrie, which is into diversified businesses such as industrial packaging, tours and travel and logistics infrastructure, currently has a dividend yield of around 5 per cent. The company has been consistent in dividend payout and profit growth.

Bank of India at 4.6 per cent yield has improved its operating performance in recent times. Also, the dividend payout ratio at around 20 per cent provides comfort. Power generator NTPC with yields above 4 per cent has slipped on the bourses, but the company’s long-term prospects seem better with reforms in the sector. Government-controlled financial institutions — Power Finance Corporation and Rural Electrification Corporation — with dividend yields of 4-5 per cent are also expected to benefit from the power sector reforms.

Private sector players

Mid-tier software player Hexaware Technologies’ current dividend yield is around 5 per cent and the company’s prospects in key verticals, such as banking, look strong.

Other good picks in the private sector are Torrent Pharma and Karur Vysya Bank (yields of around 3-3.5 per cent).


(This article was published on July 27, 2013)
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