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Suresh Krishnamurthy

BIRLA Mutual Fund launched its dividend yield fund in 2003. While none of the other mutual funds followed suit then, now, a number of them, such as Principal, Tata and HDFC, are lining up to launch funds based on dividend yield investing. Suddenly, simple dividend yield investing has turned out to be the investment mantra of the market.

Theoretically, such a strategy should not work in the marketplace at all. This is because the stock price captures the potential for total return from an investment, and dividends, especially historical ones, should not matter.

The marketplace, however, usually makes a mockery of such theories. Dividend yield strategies have worked very well in the past five years. One of the strategies is to invest in the top 10 stocks in terms of dividend yield — the `dividend dogs', as they are called — in an index such as the CNX 500.

This strategy yielded significant returns over the past five years, recording higher returns than top-performing equity mutual funds and indices.

Riding the dogs

For the analysis, the indices considered were the BSE-100, the BSE-200 and the CNX-500. Their composition was ascertained at the end of September each year, from 1999 to 2003. The top ten dividend yield stocks at the end of September were identified for each of the indices.

The average one-year total return of the top ten stocks in terms of dividend yield was calculated and compared to the returns of various indices and top-performing equity mutual funds.

The total return is the gain in price plus dividends. The average one-year return was considered on the assumption that investors would have invested equal amounts in the top ten stocks.

The analysis showed that the average annual total return for the five-year period from September 1999 to September 2004 (for the dividend dogs' portfolios) was higher than that of returns from these indices themselves.

Moreover, the average return was also higher than that of the average for the five top-performing equity mutual funds. These were Franklin India Bluechip, Franklin India Prima, Templeton India Growth, HDFC Equity and HDFC Top 200.

CNX 500 strategy tops

The strategy based on investing in the CNX-500 dividend dogs would have, however, produced the best results. Such a strategy would have lost very little value in the period September 1999 to September 2000, which was similar to the performance of the top performing equity mutual funds in that period.

In contrast, strategies based on the BSE-100 and the BSE-200 lost considerable value in that period. These two strategies also had a modest run from September 2003 to September 2004.

Between September 2002 and September 2003, the CNX-500 strategy would have delivered lower returns, (than strategies based on the BSE-100 or the BSE-200 or the equity funds) — a period in which the market was in the grip of a significant bull run.

This is, however, compensated completely by the higher returns obtained in three out of the five years. Moreover, the CNX-500 strategy had the least annual fluctuation in returns.

The annual fluctuation in returns was comparable to the volatility in annual returns of the Nifty index. The average annual returns were, however, nearly six times higher than that of Nifty.

On the parameter of fluctuation in returns, the BSE-100 index performed rather badly. The performance of BSE-200 was, however, better. It was comparable to that of equity funds.

It is not the dividends, though

A dividend yield strategy is usually compared to a race in which one of the participants has a head start. With a head start, you would naturally finish at the head of the pack. Indeed, this was true of the strategy only between September 1999 and September 2001.

Since then, stocks with high dividend yields have delivered superior total returns. The proportion of dividends in the total returns has declined.

Consider 1999-2000. In that period, in terms of prices, the top ten dividend yielding stocks of CNX-500 lost 15 per cent. The dividend yield was, however, significant — at about 8.4 per cent.

This brought down the average loss to about 3.7 per cent — a commendable performance for that year.

Consider 2000-200: Average price gain — 8.6 per cent; dividend yield — 13.5 per cent. This catapulted the average total return to 26.4 per cent - an exceptional performance for that year, and the reason was dividends.

In contrast, in 2003-2004, it was: Price gain: 52.7 per cent; dividend yield: 10.2 per cent; total return: 62.9 per cent. This strategy would have outperformed even without the dividend yield.

Dividends were less important in 2001-2002 and 2002-2003 too.

What these signify is that dividend yields emerged as powerful tools to unearth value stocks in the past three years.

Small-cap and bull-market bias

It would, however, be better to not to lay too much emphasis on this strategy's ability to deliver super-normal returns.

There are two reasons: One, the superior returns may be explained equally well by small-cap investing. Investing in small-caps generally delivers better returns than investing in large-caps or mid-caps.

The strategy of investing in the dividend dogs of CNX-500 essentially involves the same - investing in small-caps.

In each of the five years, the market-cap of five of the ten stocks chosen was less than Rs 100 crore. So, it can be argued that the returns were not due to dividends but due to the small-cap bias.

Second, the mid-cap and small-cap stocks have been in the midst of a huge bull-run since September 2001. Between September 2001 and now, the Sensex has appreciated 100 per cent.

In the same period, CNX Midcap 200 has delivered returns of 266 per cent. This could explain the superior performance of the strategy.

Alluring dividends

Despite all these caveats, the strategy is attractive and may even be an indispensable tool for the retail investor. One, it could be used to gain exposure to small-cap stocks.

That is important because mutual funds avoid small-cap stocks. Direct investing in small-cap stocks is the only way to gain exposure.

Second, it protects you from downside in a bear market. For instance, between September 2000 and September 2001, the market lost value considerably — the Nifty shed a whopping 28 per cent and the other indices lost more. The `dividend dogs' strategy, however, delivered significant positive returns. Small-cap or not, downside protection is valuable, especially now that we are on top of a bull market.

The strategy can be improvised using subjective judgments. If you pick and choose from stocks boasting of high dividend yields rather than blindly invest in the top dividend dogs, you may even generate better returns.

This way, we can even counter some of the bias inherent in any data analysis based on past price movements.

This is precisely what equity mutual funds have in mind when they launch dividend yield funds.

One way of achieving that would be to look into the company's cash flows. Add depreciation to net profits and deduct capital expenditure and change in net current assets.

This would get you free cash flows. See if this has remained stable or rising. See if the dividends as a proportion of the cash flows are not substantially high.

If the conditions are satisfied, you can then proceed to invest in the stocks.

Alternatively, if you are not game for such mathematical drudgery, you can blindly use the `dividend dogs' strategy as long as it works for you, or choose one of the dividend yield funds on offer.

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