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Suresh Krishnamurthy

For investors seeking regular income, high dividend yielding stocks offer an alternative at a time when return from debt investments are shrinking. Investors however need to be mindful of the risks associated with such stocks.

INVESTORS hamstrung by the plunging yields on debt investments are increasingly finding their way to the equity market. This is evident in the moneys mobilised by monthly income plans and the record pace in the opening of new dematerialisation accounts in recent months.

A larger number of retail investors now appear keen to invest in equities to boost their regular incomes. For such investors, dividend-yielding stocks could be an attractive option.

Incidentally, the sharp fall in prices of mid-cap and small-cap stocks in January 2004 have enhanced the dividend yield on many such stocks. If carefully picked these dividend-yielding stocks can deliver regular income and also prove to be less risky over a period.

Effective strategy: Purists abhor investing based on dividend yields. For them, the expected total return on a stock is the relevant factor. Total return on a stock includes the dividend yield plus the capital appreciation.

They rightly, point out that a focus on high dividend yielding stocks could prove myopic as large capital losses can more than offset dividend income. In practice, however, strategies based on dividends yield have worked, especially in recent times. This acts as an incentive to use this strategy to pick stocks.

Dividend yield stocks also perform an additional function — that of offering regular income.

Investing based on total returns may not provide current income and may also be tax inefficient, if part of the holdings have to be sold within a year to generate income. It is, however, essential to control risks.

Controlling risks: Studies abroad have indicated that companies whose free cash flows are increasing tend to keep raising dividends.

Dividends declared by these companies also tend to be more stable.

Investors might find it difficult to keep track of free cash flows but the following filters might prove useful:

* Growth in profits

* Growing or stable dividends

* A low dividend pay-out ratio

* A reasonably high return on net worth ratio

* A reasonably high dividend yield

These filters will ensure that dividends paid out in the previous year will at least be maintained. These stocks may perform in line with the market if the economy improves and also earn some capital gains.

On the other hand, these filters still cannot eliminate subjective judgment. Subjective judgment is needed in pruning the list to identify stocks with potential. For instance, if two stocks offer similar dividend yields, then the stock with a larger market capitalisation may be a better candidate.

Similarly, stocks of companies with poor corporate governance record may need to be avoided. In addition, we have to review the portfolio once a year to make necessary additions and deletions.

Dividend yield picks: The following filters were used to identify attractive dividend yield stocks:

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